PSS: One way of reforming the pension system
China's pension system is at treacherous crossroads. It has a pay-as-you-go (PAYG) social security system, which covers less than 30 percent of the country's workers and is financed by a 28 percent tax on the payroll of participating firms. Recent studies show non-funded liability of the pension system ranges from 120 percent to 140 percent of GDP. As the population is aging, such a funding problem will make things worse for China's future retirees and seriously damage the long-term growth prospects of the economy.
To deal with the problem, the country should set up a fully funded and egalitarian "personal security system" (PSS), which allocates all investments to a global index fund and relies on the World Bank, the IMF and the Asian Development Bank to serve as joint third-party custodians of all account assets. The system would provide the public free access to the global capital market, and gradually transform retirement account balances into inflation-protected pensions - pensions that can be accessed by retirees from ATMs anywhere in the world.
This will yield a pension system that is simple, fair, efficient, transparent, reasonably safe, internationally diversified and cheap to operate.
The PSS would work as follows. The government would have to freeze the existing system, including the minimum social benefit, so no additional benefits would be accrued on the margin. It would have to use general revenue to hand over today's retirees their current benefits on an ongoing basis and pay current workers in old age only those pension benefits accrued on the date of enactment of the PSS reform. Thus, the current system with its unaffordable costs would be retired over time.
The PSS would continue to compel saving. Indeed, it will require each worker to contribute 8 percent of his earnings to his personal security account, but with one big exception. Spouses would have half their 8 percent contribution allocated to their partner's account. This means that low-earning partners in a marriage, typically wives, would have the same size PSS account as their high-earning partner, typically husbands.
The government would have to make matching contributions on behalf of the poor, the unemployed and the physically challenged. The PSS contributions would be managed at no cost to contributors by third-party trustees. PSS contributions would be required to be invested in a global market-weighted index fund of stocks, bonds (including government bonds) and real estate investment trusts.
The independent trustees would then set up a computer system (with lots of backups) to invest electronically. Since the fund would be market weighted, the only decision to be made by the trustees would be which financial markets to include in the index. For example, the trustees may conclude that a certain country's stock market is too underdeveloped to be included in the index. But since the share of the PSS portfolio to be invested in any particular security would equal the share of that security in the world financial market's total valuation, most of the PSS investments would be made in securities issued by firms and governments in developed countries and major developing countries, including China.
The account of each worker between the age of 57 and 67 would be gradually sold off, through the independent trustees' computer, on a daily basis at no cost to the PSS participant and used to purchase shares of a cohort-specific longevity mutual insurance fund, managed at no cost by the trustees and invested in a global, market-weighted index of inflation-protected bonds.
Thus, each day over the 10-year period, a bit of one's portfolio would be sold off and used to purchase a small annuity. These annuities would start paying out when the worker turns 62, and by age 67 the retired worker would be getting his annuity in full. Workers who die before reaching the age of 67 would be able to bequeath their PSS balances to their heirs. It has to be noted that stock brokerages and other financial firms play no role in either the investment of PSS assets or their eventual annuitization.
The PSS plan is, thus, very different from the typical social security privatization proposal that forces each participant to choose his/her asset allocation, and permits the financial sector to charge huge fees for "investing" the asset (which often consists of buying just government bonds) and then to impose huge additional fees for transforming his/her account balances into annuities when he/she retires.
What about investment risk? As indicated, the PSS balances would be invested in the global financial market, including bonds, real estate trusts as well as stocks. In addition, the transformation of PSS balances would be very gradual. If one cohort has a bad history of global returns, the government could add to the PSS annuity of that cohort so that it could earn some amount.
What about currency risk? This risk appears to be negative because when the Chinese economy is doing poorly, the value of its currency is likely to fall, leading to a capital gain on foreign asset holdings. The opposite would apply when the economy does well. Hence, investing abroad is a way for Chinese workers to hedge the risk they face.
What about longevity risk? The annuitization of PSS balances would be done on a cohort-specific basis with returns paid out each year based on the cohort's updated survival probabilities. Hence, if a cohort survives longer than expected, it will receive smaller annuity payments than would otherwise occur. Again, if the Chinese government determines that this aggregate shock needs to be pooled across generations, it can easily do so by raising general taxes and using the proceeds to increase the annuities of retired cohorts.
Business as usual is not going to fix China's pension problem. The PSS can. If China adopts the PSS system, it would inspire other countries to update their social security schemes to make them more transparent and socially inclusive, as well as cheaper to manage.
Laurence J. Kotlikoff with Boston University, Shuanglin Lin with Peking University, and Wing Thye-woo with University of California at Davis are all professors of economics.
(China Daily 01/05/2010 page9)
