Population aging and pension systems : reform options for China

\J$ 1 6o0} POLICY RESEARCH WORKING PAPER 1607 Population Aging As _hinas po ulation age,- China must acdress and Pension Systems macroecononic ssues affecting its ol.-age sociai Reform Options for China security systen. rotjust the design and m,-inagemene ot pension funds F. Desmond McCarthy Kangbin Zheng The World Bank Office of the Senior Vice President Development Economics May 1996  I POLICY RESEARCH WORKING PAPER 1607 Summary findings Using an integrated simulation model, McCarthy and Reai income growth is needed to cope with poverty Zheng estimate the scope and speed of population-aging among the elderly, especially in developing countries. To in China, the cost of supporting the old, and the impact establish an adequate, efficient, and equitable social of different reform options and pension arrangements. security system, China must maintain long-term Among their conclusions: socioeconomic stability and sustainable growth. The scope and speed of popuiation-aging in China China could improve the labor market by removing make the present pension system financially management rigidities, facilitating human resource unsustainable, even assuming that GDP grows steadilv in development, making labor markets more competitive, the long term. Moving the retirement age back would improving the household registration system, improving provide a temporary fix for the current pay-as-you-go incentives, and rewarding hard and innovative work. To pension system but would be politicallv viable only reduce unemployment, China can create more job where there is great demand for labor. oppor-tunities in nontraditional sectors, especially its Pension funds could be made more sustainable by underdeveloped service industries. To shift jobs to the increasing GDP growth, raising contribution rates, or nonagricultural sector, it can develop medium-size cities. gradually reducing benefit rates. Blut the financial costs And to cushion the impact of demographic shocks, China and social obstacles of those refornm options must be should preserve traditional values and maintain family- carefully assessed. Ftully funded, privately managed community support. pension schemes might be feasible, but require a sound Drawing onI experience in Europe and Latin America, regulatory framework and institutional infrastructure, China should move toward a transparent and including financial markets that provido adequate siavings decentralized system with (1) a fully funded, portable, instruments and insurance opt'Ols. defined-benefit pension plan, designed to meet basic Pension reform is a long term, niuitidimensional needs, and (2) occupational pension plans or personal problem involving economilic, social, political, and savings accounirs to satisfy demand for maintaining or Cultural factors. Governments should not focus only on improving living standards. taxes and transfers to redistribute incone to and among the elderly. This paper - a product of the Office of the Senior Vice President, Development Economics - is part of a larger effort to study strategic and policy issues for socially sustainable development in developing countries. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Mila Divino, room N6-056, telephone 202-47/3-3739, fax 202-522-1157, Internet address mdivino@q?worldbank.org. May 1996. (47 pages) The Policv Research Working Paper Series disseminates the findings of u'ork in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry, the names of the authors and should be used and cited accordirngly. The findings, interpretations, and conclusions are the authors' oun and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries. Pro dJK d !lE t-i Policy Rcsca- h Dissemination C(( intc  Population Aging and Pension Systems F. Desmond McCarthy and Kangbin Zheng The World Bank Office of the Senior Vice President Development Economics JEL Classification Nos: H55, 138 This paper is part of a larger effort to study strategic and policy issues for socially sustainable development in developing countries. The authors thank Estelle James, Cheikh Kane, Anita Schwartz, and participants of an international economics seminar at MIT for helpful suggestions and discmssions.  I I  Contents I. INTRODUCTION I II. CHALLENGES AHEAD 4 Traditional Values 7 Demographic Transition and Population Policy 8 Structural Adjustment and Rural-Urban Balance 14 Sustainability of Socio-economic Transition 15 III. A SIMPLE SIMULATION MODEL FOR PENSION REFORMS 18 The Pension Fund Balance 19 Demographic Dynamics and Labor Market 21 Economic and Wage Growth 22 Government Behavior under Different Pension Arrangements 22 Pay-As-You-Go Scheme 23 Defined Contribution System 24 Defined Benefit System 25 Private Pension Fund Accounts System 25 A Multi-pillar Pension System 26 IV. PENSION SYSTEM REFORM IN CHINA 27 The Current Pension System in China 27 The Need for Pension Reforms: The Benchmark Case 31 Base Year Paramneters 31 Key Assumptions 31 Pressure from Population Aging 33 The Base Case Scenario 35 Policy Simulations for Reform Options 37 Delaying Retirement Age 37 Change of GDP Growth Path 39 Changing the Contribution Rate and the Replacement Rate 41 Fully Funded Individual Accounts 41 V. PRELIMINARY CONCLUSIONS 43 REFERENCE 46 i  List of Figures Figure 1 Development Diamond 1992 6 Figure 2 Population Aging 10 Figure 3 Population Growth 1985-2150 11 Figure 4 Average Age of Population 1985-2150 12 Figure 5 Evolution of Age Structure 13 Figure 6 Links Among Pension Performance and Socio-Economic Development 18 Figure 7 Public Pension System Development 1978-1993 30 Figure 8 Population Dependency Rate With Different Sets of Retirement Age 38 ii  Population Aging and Pension Systems 1. Introduction While being proud of its civilization as one of the world's oldest, China, though relatively youthful at present, is getting older rapidly and massively. Strict family planning practice has sharply reduced fertility since early 1980s. Better living conditions and medical services have cut down mortality and extended life expectancy in both urban and rural areas. Consequently, the percentage of older persons in the total population increases continuously, and the median age of the population rises steadily. Moreover, the aging process is expected to accelerate in the coming decades as the baby boomers born between early 60s and mid-70s, currently numbering more than 250 million (twice Japan's present total population), approach retirement age around 2030. By then as many as 22 percent of Chinese nationals will be more than 60 years old, jumping from 9.7 percent in 1995. During the same period, the ratio of working-age persons to the aged is estimated to be halved from 9.7:1 to 4.2:1. Without a properly designed social security system and strategically formulated policy responses, it would be very difficult for China to cope with this coming old-age challenge. The pressure generated from these demographic dynamics for China in the 2030s share some similarities with those facing Western developed countries and Japan in the next decade. However, China is a low-income country, with per capita income of US$ 490 in 1993 being less than 2 percent of that in the United States at the current market exchange rate, or close to 10 percent when measured at purchasing power parity'. Apparently, China's quick population aging process and lower level of development mean that income resources available to support non-productive aged people will be far less I The World Bank's World Development Report 1995 , page 220, presents a cross country comparison of PPP estimates of GNP. Here China's per capita GNP in 1993 is estimated at US2,330 as compared with that of India at US$1,220. 1  than in the developed world. Even with the Confucian tradition of filial piety and respect for the elderly, China with relatively fewer young will soon find itself in difficulties to provide adequate support to its rapidly increasing old-age population. Faced by these serious challenges for harmonizing economic growth with social sustainability, the Chinese government has begun to take measures to reform its currently fragmented social security system. Policy options on pension system reforms have been studied, and several experiments for social security decentralization have been carried out at provincial and municipal levels. State and collective enterprises began pooling pension funds in order to ease uneven burden of retirement costs. However, many long-term strategic issues on the interdependence between demographic transition and economic growth remain to be systematically investigated. For instance, what is the real financial burden the population aging process creates, given the fact that both the income growth rate and the average private savings rate in China rank among the world's highest in recent years and will probably continue to be so in the near future? What are the macroeconomic implications if the current pay-as-as-go type of pension scheme were not reformed? How to deal with the insolvency of pension funds associated with state-owned enterprises? What roles shall individual workers, enterprises, and different levels of governments play to establish sufficient, efficient, and equitable social security systems? How can pension funds be most effectively managed, privately or publicly? How are different schemes socially and financially sustainable? What are the political implications associated with pension system reforms since any adjustments on this front will inevitably necessitate inter- generational transfers and intra-generational redistribution among different income groups? How much can China learn from experiences of both developed and developing countries? This paper seeks to make a contribution to policy thinking on these important questions. The theme of the paper is that issues around the old-age social security system in most developing countries, such as China, need to be addressed in a broader macroeconomic sense rather than over-stressing on design and management of the pension 2  funds pe se. The ultimate means to endure and improve living standards for the old population is to maintain long-term stability and promote sustainable income growth, while reforming micro-incentive structure to encourage private savings. Workers, pensioners, enterprises, and different levels of governments need to cooperate to improve labor productivity, create new job opportunities, preserve traditional and family values, liberalize and develop financial markets, and rationalize government interventions in the social security system. There exist extensive discussions, as cited in World Bank (1994), on pension schemes and social security systems. However, only a few are directly concerned with policy applications in China2. Using a simple simulation model similar to that of Schieber and Shoven (1994) and the World Bank's population forecasting for China (World Bank 1995), this paper attempts to quantitatively illustrate: (a) the scope and the speed of population aging and its associated cost of supporting the old in the future, (b) whether a typical pay-as-you-go system is sustainable and how large the cost if no reforms were conducted, and (c) system sensitivities with respect to alternative policy choices. Although other kinds of benefits and compensations, such as health insurance and disability benefits, are integral parts of the social security system, the focus here is maintained on pensions for retired persons. The rest of the paper is organized as follows. Section II analyzes major challenges China will face during its demographic and socio-economic transition. Section Im presents a simple model built around a pay-as-you-go system which integrates demand for old age supports with supply of funds available from workers' contribution. Section IV focuses on the sustainability sensitivities of different policy alternatives. Section V concludes this paper with some remarks and suggests directions for further policy studies. 2 A partial list of studies on pension system reform in China includes Ahmad and Hussian (1991), Barkan (1990), Dixion and Macarov (1992), Hu (1994), Hussain (1993,1994), Hussian and Li (1989), Lee (1993), Tian (1995), World Bank (1990, 1994), and Yue (1985). 3  11. Challenges Ahead Living on about 7 percent of the arable land of the earth, China's population of 1.2 billion accounts for about 21 percent of the world's total and surpasses that of India, the second largest in the world, by more than 30 percent. Significant socio-economic progresses, as shown by the indicators in Table I in terms of both development dynamics and international comparison, have been made in the past decades. These achievements are especially apparent within the past 15 years, when market reforms and integration into the world trade and finance systems resulted in noticeable improvement in production efficiency and income growth. Within the period between 1980 and 1994, real GDP grew at a rate close to 10 percent per annum on average, the number of persons living in absolute poverty was halved, and the international trade volume rose by five to six times to more than US$200 billion. This remarkable growth was largely financed by domestic savings, although foreign financial assistance through investment and lending also played an important role. As exemplified in the 1992 Development Diamond presented in Figure - 1, China compares favorably with most low-income economies in all four dimensions. While fundamental transformation and economic growth will probably continue at a fast pace in the first decades of the twenty first century, a number of concerns for long term sustainability are emerging. The old-age security system is one of more pressing. Out of many social, political, and economic factors that can generate significant impact on the social security system in the near future, the following four intertwined factors are central for policy formation to avert a potential old age crisis: (a) how to promote growth while preserving traditional values? (b) how to adjust population policies to cope with the demographic development? (c) how to divert labor force concentration from agriculture to industries and services while maintaining rural-urban balances? and (d) how to mitigate the social cost during the transition from a central planning regime towards a competitive market economy? 4  Table I Basic Indicators of Social and Economic Development (1993 unless otherwise stated) Other Low- Middle- China India Income Income World Economies" Economies Population million 1178 898 1015 1597 5501 Urban % 29 26 27 60 37 Growth Rate (80-93) % 1.4 2.0 2.5 1.7 L7 Total Fertility Rate 2.0 3.7 5.5 3.0 3.2 Life Expectancy years 69 61 56 68 66 Adult Illiteracy % 27 52 49 17 33 Primary Net Enrollment % 96 57 Access to Safe Water % 71 75 GNP per capita USS 490 300 300 2480 4420 GDP Growth Rate (80-93) % 9.6 5.2 2.9 2.1 2.9 Avg. Inflation Rate (80-93) % 7.0 8.7 27.1 90.1 19.6 Exports US$ bil. 91.7 21.5 43.2 648.2 3701.5 Growth Rate (80-93) % 11.5 7.0 1.4 Imports US$ bil. 103.1 22.8 62.9 724.6 3778.7 As Share of GNP Gross Domestic Investment % 41 24 17 23 22 Gross Domestic Savings % 40 24 10 22 22 Agriculture % 19 31 37 Industry % 48 27 22 Service % 33 41 42 Source: World Bank (1995): World Development Report 1995: Workers in an Integrated World 1/ excluding China and India. 5  Figure 1 Development Diamand: 1992 Low-Income Economies excluding China and India = 100.0 180.0 - GDP per capita 160.0 14 0 20.0'-\ Access to Safe Water Life Expectancy \ / / -~~China - - - Low-Income Economies Gross PrimaryErollExcluding China & India Gross Primary Enrollment  Traditional Values For thousands of years, traditional values in China have placed strong emphasis on the role of the family as a unit of production and consumption in general, and as a basis for raising the young and supporting the old in particular. Three or four generations usually live under the same roof to pool resources and share risks. When grandparents in ordinary families become too old to generate income directly from working outside, they stay at home not only to just rest but to take care of young grandchildren and do housework in order to reduce burdens of the rniddle generation. This system worked quite well, often in the absence of any formal market work arrangements. The virtues of diligence, frugality and thrift are glorified. Accumulation of social experience and financial wealth, largely bequest-motivated, by the old through their life-long hard work wins them respect from the society. Thus the welfare of older members has been an essential responsibility of families, as a reward to the altruistic spirit of the older generation. This traditional natural harmony between generations within the family and among members of a community is now being disrupted as the economy modernizes and opens to extemal influences. The families themselves are getting smaller, especially in urban areas because of housing problems. While a higher percentage of family members are living longer, traditional extended family living arrangements are being stressed by the need for some members to become more mobile to respond to new economic incentives. Understandably in an increasingly secular society more activities are valued through market interactions, and there is often more emphasis on self gratification and less on commnunal responsibilities. In China, significant importance needs to be attached to preserving the tradition of respecting and supporting the old on family and community basis. Currently, China's big population is mostly rural with low income. About 10 percent of the population are still living in absolute poverty with an income less than half a dollar a day. In addition, 27 percent of adults are illiterate. For persons 60 years or older, about one in ten women and two in ten men can actually read and write. Socialized old-age security systems through operations of pension funds and insurance arrangements are unlikely to play a major role until later in the next century, because of China's current development level of economy 7  and infrastructure. Nursery homes, if built to house China's 360 Million old persons in the 2030s, would be very costly and labor-intensive, and may not necessarily provide better services to the elderly than within a family atmosphere. Hence, how to preserve and promote traditional family values shall be a key policy issue in designing old-age security systems in China. Demographic Transition and Population Policy Another challenge comes from the inertia of the demographic transition. China's population, unevenly distributed across regions, is projected to grow at an average annual rate of less than 0.9 percent between 1995 and 2030. This growth rate is only a half of the 1.8 percent rate between 1970 and 1980 and substantially lower than 1.4 percent rate between 1980 and 1993. But the size of the incremental population is enormous because of the much larger population base. Close to a net of 430 million people will be added to China's population within the next 35 years, which is equivalent to five times of the current total population in Germany. More than half of this increase can be attributed to extension of life expectancy, which is forecast to advance from 69 years at birth in 1995 to 75 years in 2030. By 2030, close to 30 percent of the world's incremental old-age population, as compared with that in 1990, will be accumulated in China. The normal population aging process seen in most countries has been particularly rapid in China during a long period of steady growth, when overall economic conditions improve and access to better health facilities becomes wider. In France, 140 years elapsed before the proportion of the population over 60 doubled to 18 percent in 1976. It will take China just 34 years. The old-age dependency ratio will rise from 15 in 1995 to 38 in 2030, while the average age of the population increases by 8.3 years from 29.4 in 1995 to 37.7 in 2030. Table 2 below summarizes some trends of the demographic development in China. Figures 2 to 5 plot some indicative demographic trends of China based on the population projections of the World Bank. 8  Table 2 Basic Indicators of Demographic Development Other Low Middle- China India Income Income World Economies Economies Annual Population Growth 1970-1980 % 1.8 2.2 2.5 1.9 1.8 1980-1993 % 1.4 2.0 2.5 1.7 1.7 1993-2000 % 0.9 1.8 2.9 1.4 1.5 Labor Force: 1993 As% of total population % 60.0 38.0 37.9 Participation Rate % 91.5 67.4 83.9 Engaged in Agriculture % 61.0 63.2 Infant Mortality Rate 1970 0/00 69 137 135 74 1272 1993 0/oo 30 80 89 39 42 Total Fertility Rate 1970 0/00 5.8 5.5 6.5 4.5 4.8 1993 0/00 2.0 3.7 5.5 3.0 3.2 2000 0/00 1.9 3.2 4.9 2.7 2.9 Crude Birth Rate 1970 0/00 33 39 45 31 32 1993 0/00 19 29 40 23 25 AgeDependencyRatio: 1993 52 77 121 81 73 Urban Population Growth 1970-1980 % 3.0 3.7 4.2 3.3 2.6 1980-1993 % 4.3 3.0 4.2 2.8 2.6 Source: World Bank (1995): World Development Report 1995: Workers in an Integrated World 9  Figure 2 China: Population Ageing 45.0 30.0 43.0 25.0 41.0 ' 39.0 20.0 E