From private pension systems to cross-border investing, China’s emergence in the global economy presents risks and rewards.
Over four decades, China’s government built a social safety net so strong it became known as the “iron rice bowl.” Under state-sponsored programs, the government supported its billion-plus citizens throughout their working lives, into retirement and beyond. With its emergence as a global economic powerhouse, the once ironclad social system is facing the need to adapt to the demands of the 21st century.
With a rapidly aging population, China faces projected implied pension liabilities in excess of US$1 trillion by 2010, according to estimates by the World Bank. Only 14% of the country’s active population has pension coverage, according to the July 2006 McKinsey Quarterly.
Those challenges for the state present opportunities for companies doing business in China. Amid growing concerns, the Chinese government has taken steps to encourage the growth of private pensions. A key component is the creation of programs called Enterprise Annuity plans, partially funded by corporate contributions.
“The government increasingly recognizes that it will need support from the private sector to facilitate post-retirement social security.”
— Kevin Tan
Chief Representative, Northern Trust, Beijing
“Historically, the state has always been responsible for the post-retirement savings,” says Kevin Tan, chief representative of Northern Trust in Beijing. Tan’s current role is to act as a liaison with the Chinese government and to advise multinational firms on how to design a pension plan in China that works with their other programs globally.
“Now the government increasingly recognizes that it will need support from the private sector to facilitate post-retirement social security,” Tan says. “Thus, the introduction of Enterprise Annuity plans.”
The development of private pension funds could grow in tandem with investment opportunities, observers note. “While regulations currently restrict companies to investments in Chinese financial products, the restrictions will likely be loosened in coming years,” Tan says. The country’s National Social Security Fund recently received approval to begin investing a percentage of its some 201 billion yuan (about US$25 billion) in assets in overseas markets, according to XFN Asia.
That small step is likely to spawn dramatic changes. In 2004, the Ministry of Labor and Social Security began accepting applications for companies to set up Enterprise Annuity plans, which have been compared to defined contribution plans. Roughly 25,000 companies have applied for and been given approval to sponsor the Enterprise Annuity plans, but funding is still in its infancy. And most plans are currently putting the funds for these in bank deposits and short-term instruments.
Last year, the government began awarding licenses to financial firms to help administer the plans.
Promoting the growth of private pensions will present risks and rewards to multinational firms doing business in China. One benefit seems obvious. As Tan points out, “The establishment of post-retirement accounts and plans will be a good tool to retain quality staff.”
Tom Benzmiller, managing director of Northern Trust in Hong Kong, notes the difficulties many companies face in retaining staff.
China faces projected implied pension liabilities in excess of US$1 trillion by 2010, according to estimates by the World Bank.
“A young person with a Western education and a couple years of experience with a multinational can basically write their own ticket right now,” Benzmiller says. “Employers are paying top dollar, and that is creating volatility as people move from job to job. That is becoming a challenge from a compensation and wage-inflation perspective. So these types of pension benefits can be another instrument for retaining great people.”
In fact, some multinational companies have been operating saving schemes in China as a means of retaining staff even before the introduction of Enterprise Annuity plans.
In addition to holding on to talented employees, Tan says multinationals can serve as examples to the government as well as Chinese companies on how to create good human resource policies. “We can help local employers set up a more stable workforce,” Tan says.
The conundrum for the Enterprise Annuity plan sponsor lies in where to invest pension contributions. At present, the regulations restrict companies to investing only in Chinese financial products. These include fixed-income vehicles and pooled funds that invest in securities listed on the Shanghai and Shenzhen stock exchanges.
Such a restriction could pose a big risk to institutional investors. Kenneth Lieberthal, a business professor and director for China at the William Davidson Institute with the University of Michigan, says investing in China’s stock markets doesn’t mean that investors will benefit from China’s booming economy.
“Since 2002, China has had an average rate of growth of a robust 10%, but both stock markets are worth less now than they were then,” Lieberthal says. “What is driving these markets is different from anything attached to real value in the economy.” Benzmiller agrees that Chinese stock markets are volatile but he notes that those markets have been faring well this year. He believes institutional investors can calm burgeoning markets.
“One feature currently influencing the Chinese stock market is smaller investors attempting to tactically allocate funds,” Benzmiller says. “You see money flow into an asset class or fund family and then you will see it flow out just as fast.
We believe that over time, strategic, long-term investing will catch on as it has in other parts of the globe, and this will be led by the large institutions.”
That’s where multinational investors can help lend some perspective. With more investing experience under their belts, they understand the importance of long-term investment goals. “This is a win-win situation for multinational firms because it helps the Chinese economy,” Tan says. “These multinationals are exactly the institutions that the Chinese government wants to encourage to be in the Chinese market.”
For a multinational operating in China, the rewards of establishing private pension schemes can be significant: maintaining great talent, supporting the government in creating social welfare programs and helping build the Chinese economy for the long haul. Those benefits will be countered by the expense and complexity of a system that is still getting started, Tan and Benzmiller say.
“We believe that over time, strategic, long-term investing will catch on [in China] as it has in other parts of the globe, and this will be led by the large institutions.”
— Tom Benzmiller
Managing Director, Northern Trust, Hong Kong
As an example, current regulations call for licensing in four different areas to serve the Enterprise Annuity market: asset managers, trustees, custodians and administrators. No single firm has been granted all four licenses, although licensees are starting to build alliances. “That means pension managers can’t make one phone call and set up a plan with one company,” Benzmiller notes.
“While Northern Trust has yet to apply for licenses to serve China’s pension plans, we have arrangements with firms that hold these licenses,” he says.
There is currently not a clear tax advantage for private organizations to fund retirement schemes. There is no national tax break for contributions to these plans, and only some provinces and cities provide tax relief. Fees for these plans also are more expensive than in developed countries, making the initial setup for the plans costly.
Tan says many of these riskier issues should be worked out as China’s corporate-sponsored pension system matures. In the coming years, it is very likely that companies could be allowed to invest a portion of their assets in overseas financial products. The government will probably work out effective tax incentives, Tan says. Also, as the market matures and grows in size, plan sponsors should begin to see their expenses ease.
In the short term, to deal with the complexity, Northern Trust suggests seeking out advice from respected advisors — including financial partners that multinational companies already trust worldwide.
In 2004, Xin Wang, a fellow at Harvard University’s Kennedy School of Government, wrote in China & World Economy that China’s attempt at building a partially funded private pension system would require the “support of the capital markets and will have a profound impact on the capital markets.”
“After the establishment of a funded pension system, pension assets grow very quickly,” he wrote. “More money becomes available for capital markets.”
As examples, Wang cited pension reforms in Chile and Argentina. The reforms were largely responsible for spawning an industry of mortgage bonds, corporate bonds and public-agency bond markets, along with venture capital and infrastructure funds, he noted.
The benefits for capital markets are less apparent in countries with underdeveloped stock markets, however. The pension fund allocations flow mainly to fixed-income vehicles, which are less likely to stimulate capital market development.
Pension fund investment styles, with their long-term horizon and predictability, add a calming effect in securities markets, Wang wrote. Pension funds across the globe have also served as shapers of corporate governance. “As long-term investors and shareholders, pension funds pay close attention to the management of invested companies,” Wang noted.