\Al PS 10+:4
POLICY RESEARCH WORKING PAPER   1674
How  Can China Provide                                                If China implements a partially
funded multipillar pension
Income Security for Its                                               system, that reform must go
Rapidly Aging Popu.latio.nhand-in-hand with reform of
the financial sector and
restructured investment
Barry Friedman                                                        procedures that emphasize
Estelle James                                                         the 'right" mix of competition,
Cheikh Kane                                                           diversification, and regulation.
Monika Queisser                                                       Otherwise, pension reform
will ultimately fail.
The World Bank
Policy Research Department
Poverty and Human Resources Division
October 1996



POLICY RESEARCH WORKING PAPE[R  1674
Summary findings
Friedman, James, Kane, and Queisser discuss key choices         Partial funding is necessary to avoid large increases in
policymakers face about China's pension system in the           future contribution rates.
face of a rapidly aging pop ulation. (Manyc developing            They investigate the impact on the old-age system and
countries face the same problem, hbit China's problems          economic growth of a multipillar system that includes a
are exacerbated by the long-ternm  effects of its one-child     modesr mandatory tax-financed basic benefit plus a
family planning policy.) Thev describe the problenis the        mandatory fully-funded defined-contribution (individual
current pay-as-you-go system  faces in the near and long        account) scheme.
term and simulate policy options for solving those                Implementation of a partially funded multipillar
problems.                                                       pension system must go hand-in-hand with reform of the
They find that simple design changes -- such as               financial sector and restructured investment procedures
reducing the generous benefit rate, moving toward price         that emphasize the "right" mix of competition,
indexing rather than wage indexing, and raising the             diversificationi, and regulation. Otherwise, China's
retirement age -  are necessary hut not sufficient              pension ref(orm will ultimately fail.
conditions for making the pension system sustainable.
This paper - a product of the Poverty and Human Resources Division, Policy Research Department - is part of a larger
effort in the department to analyze the impact of pension systems and pension reform. Copies of the paper are available
free from  the World Bank, 1818 H Street NW, Washington, DC, 20433. Please contact Selina Khan, room  N8-024,
telephone 202-473-3651, fax 202-522-115.3, Internet address skhan8(Qvworldbank.org. October 1996. (51 pages)
7he Policy Research Working Paper Series disse tinates the findings of work in progress to encouragc the exchange of ideas about
development issue's. An objec tiue of thc serirs is to get the findings out qut klv, even if the presentations are less than fully polished. The
papers carry the narmes of the authors and should he used and itled ac- ordini'!y. 7The findings, in terpretations, and conclusions are the
authors ou-n and should n. t be attributed to the WVorld Bank, its Executive Board of l)irec tots. or aniy of its member countries.
Pr sdUccd lhv the Puhicv Rusv arch Disseinination <einter



HOW CAN CHINA PROV7IDE INCOME SECURITY FOR ITS RAPIDLY AGING POPULATION?
by
Barry Friedman, Brandeis University
Estelle James, World Bank
Cheikh Kane, World Bank
Monika Queisser, World Bank






Table of Contents
HOW CAN CHINA PROVIDE INCOME SECURITY FOR ITS RAPIDLY AGING POPULATION?
Abstract       .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .
I.  Introduction and Summary  . . . . . . . . . . . . . . . . . . . . . . .1
II. The Current System: Problems and Alternative Solutions  . . . . . . . . 4
The Short Run Problem: High Costs for SOE's and Limited Pooling . . . 4
The Long Run Problem: Population Aging and Limited Coverage . . . . . 7
Alternative Policy Solutions:
Simple Design Changes Versus Basic Reform . . . . . . . . . . . . . 8
III. Effects of a Continued and Reformed PAYG System  . . . . . . . . . .  10
Basic   Assumptions    .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  10
Cost of the PAYG System Under Alternative Reform  . . . . . . . . .  13
The   Current   System  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  14
Benefit Rate and Retirement Age:
The High Cost of Early Retirement . . . . . . . . . . . .  15
Price Versus Wage Indexation  . . . . . . . . . . . . . . . .  16
Financial Market Reform . . . . . . . . . . . . . . . . . . .  17
Combined Reforms and Coverage Expansion . . . . . . . . . . .  18
IV. Partially Funding in a Multi-Pillar Systems . . . . . . . . . . . . .  19
The Rationale for a Multi-Pillar System . . . . . . . . . . . . . .  20
Risk in the Single-Pillar and Multi-Pillar Systems  . . . . . . . .  24
The Cost of the Multi-Pillar Systems; and How
to Finance the Transition . . . . . . . . . . . . . . . . . . .  26
Transition Costs Paid by Present Worker Cohorts . . . . . . .  27
Transition Costs Spread Over Many Generations Through Borrowing 27
Extended Coverage and Broader Pooling . . . . . . . . . . . .  28
Comparisons Among Alternative Systems . . . . . . . . . . . .  30
Use   of   SOE   Assets    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .  31
V.   Conclusions   and  Risks  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  33
Appendix: Notional Defined Contribution Plans . . . . . . . . . . . . . .  38
Tables
1. Population Aging in China  . . . . . . . . . . . . . . . . . . .  40
2. Baseline and Alternative Assumptions . . . . . . . . . . . . . .  41
3. Break Even Contribution Rates for Reformed42
PAYG Defined Benefit System  . . . . . . . . . . . . . . . . . .  42
4. Uniform Contribution Rates for Partially Funded
Defined  Benefit  System   .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  43
5. Replacement Rates Under Multi-Pillar System,
for 19 Years of Expected Retirement . . . . . . . . . . . . .  44
6. Annual Contribution Rate Needed for Multi-Pillar System,
Including Transition Costs  . . . . . . . . . . . . . . . . .  45
7. Uniform Contribution Rate Needed for Multi-Pillar System,
With Borrowing to Cover Transition Costs  . . . . . . . . . .  46
8. Annual Surplus and Total-Funded in Transition
Account   and  Pillar  I    .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  47
Figures
1. Trade-Off Between Retirement Age and Contribution Age  . . . . .  48
2. Trade-Off Between Retirement Age and Replacement Rate  . . . . .  49
3. Pension Relative to Average Wage Under Price
and 50% Real Wage Indexation . . . . . . . . . . . . . . . . . .  50
4. Relative Position of Young, Old and Very Old Under Price
and 50% Wage Indexation  . . . . . . . . . . . . . . . . . . . .  51
5. Impact of Expanded Coverage on Contribution Rate,
and Comparison to Transition Costs . . . . . . . . . . . . . . .  52
6. Comparison of Alternative Systems  . . . . . . . . . . . . . . .  53
References     .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .    .  54






HOW CAN CHINA PROVIDE INCOME SECURITY FOR ITS RAPIDLY AGING POPULATION?
I. Introduction and Summary
As in many developing countries, China's population is aging rapidly, due
to fertility policies that have depressed the number of children combined with
rapid medical improvements that have prolonged life for the old (Table 1). By
2030 over one quarter of the world's old people will live in China. While those
over 60 accounted for 9% of China's population in 1990, they will be 22% in 2030
and 26% in 2050. It will take China only three decades to reach the 1990 OECD
level of 18%, while in most OECD countries it took nearly a century for the
proportion over 60 to double from 9% to 18%. In 2030, China's proportion will be
50% higher than many of its likely competitors in Asia, such as India, Indonesia,
Malaysia or Vietnam.
This aging process will have far-reaching consequences.   Socially, the
family will be strained, perhaps more than in other countries, because of China's
"one child policy".  Economically, escalating costs associated with the aging
population could put China at a competitive disadvantage relative to its
neighbors. If current systems are unchanged, rising payroll tax rates needed to
cover sharply increased medical and pension costs could dampen China's growth in
wages and employment, induce evasion and escape to the informal sector, and will
inevitably mean large intergenerational redistributions. China is considering a
number of reforms to prevent this from happening.
This paper focuses on the pension system, discusses key policy choices, and
evaluates their impact on costs and benefits as China's population ages. Part I
describes the current pay-as-you-go (PAYG) system and the problems it faces in
the short and long run; such a system is very sensitive to changing old age
dependency rates. In a PAYG system, the pensions of old people today are financed
by contributions of young workers today, rather than by their own savings in the
past. Parts II and III simulate several policy options for solving the problems
that will be faced by this system in the near future. Simple design changes
involve reducing the generous benefit rate, moving toward price rather than wage
indexation of pensions and raising the retirement age. The trade-offs among these
options are explored in Part II. The central question asked here is: Will these
1



reforms alone suffice to solve the aging problem? Simulations indicate that the
answer is "no".
More basic reforms would move away from a straight PAYG system to a
partially funded system that smooths contributions over time. In addition,
partial funding can enhance economic growth by increasing capital accumulation.
While China's rate of voluntary saving is very high now, it may not be so high
in the future, so policies that augment long term saving may be desirable. If the
savings are well invested, this ultimately raises the affordable benefit or
lowers the required contribution rate.
This leads directly to a key issue--how should the funds be managed to
maximize the returns? Who should choose the investment managers? What incentives
and constraints will the managers face? Should the funds be publicly or privately
controlled? Another important question is the choice between defined benefit and
defined contribution plans. In a defined benefit plan, pensions are promised that
usually depend on the number of years worked and the wage in the last few years
of employment, but the future contribution rate needed to pay for these promises-
-and therefore their credibility--is unspecified. In a defined contribution plan
the contribution rate is defined and the pension ultimately depends on
accumulated contributions plus investment returns, but future interest rates and
benefit amounts are uncertain.
In Part II the entire system is assumed to be defined benefit and any funds
that accumulate are publicly managed. Part III investigates the effects of
instituting a multi-pillar system that includes a modest mandatory tax-financed
basic (defined) benefit plus a mandatory fully funded defined contribution
(individual account) scheme. The first pillar is publicly managed and designed
to provide a social safety net through redistribution targeted toward low income
workers, while the second pillar requires people to save in their own individual
accounts and is privately managed. Thus the multi-pillar system combines publicly
and privately managed components, that are pay-as-you-go and defined benefit,
funded and defined contribution, respectively. (See World Bank 1994, which
describes this system and its advantages in a more general context).
Many Chinese officials consider such a system desirable--but implementation
has been stalled by the transitional costs that would be implied. Shifting to
a multi-pillar system would require paying off the implicit debt (honoring the
2



promises) of the old system while also funding the individual accounts in the new
system, a requirement which, in many countries, has stopped such reforms. This
paper investigates ways in which this debt could be paid off, including the
feasibility of borrowing in the early years and repaying later on, with taxes or
proceeds from SOE assets as alternative sources of funds for repayment.   The
Conclusion summarizes the recommendations that come out of this analysis, as well
as the inherent risks.
Under reasonable assumptions, it seems that maintenance of the current PAYG
system will require a doubling of the current payroll tax rate by 2030 and a
trebling by 2100. Simple design changes to the PAYG system substantially cut
these rate increase, but do not appear to be a sufficient solution. However, a
combination of these design changes--together with partial funding and a
transition to a multi-pillar system in which the funds are competitively managed-
-will enable China to provide income security for its aging population into the
twenty first century with a lower contribution rate than it currently requires,
without large intergenerational transfers, and with beneficial effects on the
broader economy.
Simulations show that the pay-off of the pension debt is quite manageable,
in part because of the low initial coverage rate for the country as a whole.
It can be financed by a 1.5% payroll tax for 105 years or 3% for 55 years (or the
equivalent in other taxes or SOE assets), while the new system as a whole
(including the transition cost) would require an 18% payroll tax--quite
reasonable by international standards, for an aging population.
This transition is greatly facilitated by:
1) borrowing to pay off the pension debt, thereby spreading the transition
costs across several cohorts;
2) coverage extension and broader pooling, which spread the costs and risks
of the basic benefit across a wider group of workers and enterprises within each
cohort; and
3) China's rapid rate of economic growth, providing the benefit formula
does not require pensions to go up as fast as wages.
Necessary institutional conditions for the success of the new system are:
1) the ability of the central government to obtain compliance from local
governments and nonstate enterprises and
3



2) financial markets and regulatory policies that enable the pension funds
to be allocated to their most productive uses and to earn a rate of return that
reflects this productivity.
These results should hold for other countries as well, especially for Asian
countries that presently have high growth and low coverage rates.
II. The Current System: Problems and Alternative Solutions
The formal pension system in China is largely urban-based, PAYG and offers
a defined benefit  that depends on the worker's wage  in the last year of
employment. Covered retirees also receive housing, medical benefits, other
services and inflation subsidies. In urban areas the pension system has been
largely  focused  on  state  owned  enterprises  (SOE's)  and  older  collective
enterprises (COE's) . Only a minority of workers are covered in the new non-state
sector (joint ventures, joint stock companies, private companies, foreign
enterprises, self-employed) , which accounts for a rapidly growing share of
employment. Very few workers in rural areas, including workers in the rapidly
expanding township and village enterprises (TVE's), are part of any formal
pension plan. Less than a quarter of the working-age population over-all is
covered.
The Short Run Problem: High Costs for SOE's and Limited Pooling
During the period of the Cultural Revolution, each state enterprise was
responsible for paying the pension benefits of its own workers, on a PAYG basis.
This meant that older enterprises with many retirees had far higher pension costs
than young enterprises. Although wages were low, partial compensation was
provided in the form of high wage replacement rates upon retirement. Since the
proportion of old people was generally small and the government stood ready to
fund any deficits, this high cost and the disparity among enterprises did not
matter in a planned economy. However, it became an increasing problem when the
Cultural Revolution came to an end and China's economy became more market-
oriented. Declining state enterprises found it difficult to keep their pension
promises, uneven payroll taxes exacerbated their inability to compete, and banks
were pressured to help enterprises meet their obligations by making unsound loans
that might never be repaid.
4



In response to the difficulties enterprises have had in paying pensions,
over the past decade most municipalities have tried to "pool" the contributions,
benefits and risks across enterprises. Pooling has eliminated some of the
problems, but since the state sector is growing slowly relative to the rest of
the economy, the ratio of pensioners to workers is high for the pool as a whole.
Moreover, since pooling is incomplete, risk-sharing is limited and state
enterprises still do not operate on a level playing field with each other or with
nonstate enterprises.   In some cities only part of the total pension bill is
pooled, so that enterprises with large proportions of retirees still pay higher
contribution rates, and different groups of enterprises in a locality (SOE's,
COE's) often belong to different pools. For example, in Shenyang, each enterprise
is supposed to pay 40% of its own pension bill, plus an 18% payroll tax to
finance the remaining 60% on a pooled basis.
Some municipalities have a concentration of declining state enterprises
with many retirees and few workers, while others have relatively new enterprises
with few retirees. The pools can provide pensions to workers if a small number
of enterprises go bankrupt, but their capacity to absorb a wave of bankruptcies
has not been tested. Pension portability is usually permitted within the pool,
but since the pools are limited in scope so too is worker mobility. Portability
of pensions across municipalities and provinces requires special arrangements
which may not be feasible.   The management and record-keeping burden of the
pension system still rests heavily on the individual enterprises; potential
economies of scale from centralized administration are not realized.
In addition, SOE's in financial difficulty are sometimes excused from
paying their share of the pension burden, eleven industries are allowed to
maintain their own pools on a nation-wide basis, and nonstate enterprises which
constitute the growth sector are only sparsely covered. The latter groups tend
to have a relatively young work force and few retirees; their exclusion avoids
cross-subsidization away from them and keeps the dependency and contribution
rates high for the others.
Benefit rates continue high relative to wages, in part because (partial)
wage indexation of pensions is used. The average replacement rate is over 80%
of wages,  compared with 40-60%  in other countries.   And the duration of
retirement is long, since retirement ages are low relative to the rising life
5



expectancy in China. The high costs of these high benefits lead to evasion and
exemptions, which raise the required contribution rate still higher. Although
pension costs are only 15% of the covered wage bill, the average break-even
payroll tax rate exceeds 20%, higher than in most OECD countries. The cumulative
tax for all social insurance often exceeds 35%, the cumulative cost of all
benefits for retirees is much greater, and imperfect labor markets may prevent
these costs from being passed on to workers in the form of lower wages.
Consequently, an enterprise may lose competitiveness not because its efficiency
in its core business is low, but because it, or its municipality, has many
retirees, hence high costs of pensions and other generous social services (health
care, housing) that they provide to retirees, a legacy from the past.
Restructuring of SOE's has been slowed down by these costs.   (For further
information on historical background and current problems see Friedman and
Hausman).
Thus, pooling at the municipal level alone has not solved the short run
financial problem of the SOE pension system or its impact on the broader economy.
The Lone Run Problem: PoDulation Aaina and Limited Coveraa.
Added to this immediate problem in the state sector is the longer run
problem caused by rapid population aging. The system old age dependency ratio
(i.e. the number of pensioners divided by the number of covered workers) will
double from 211 in 1995 to 42% in 2030, continuing to 55% in 2050 and 71% in
2100, respectively, if retirement age, urban/rural migration and coverage do not
change (Table 1) . Realizing that the costs implied under a PAYG system would
become unaffordable and distortionary, the Chinese government is anxious to
partially prefund its future pension obligations.
Prefunding would not only smooth the contribution rate over time and reduce
intergenerational transfers, it would also enhance economic growth by
accumulating savings for long term investments and facilitating financial market
development. However, in China as in other countries, it is proving difficult to
finance the transition from PAYG to funding--paying the benefits of current
retirees while also prefunding future retirees. Because of the desire for
prefunding, individual retirement accounts for covered workers are being set up
in most municipalities, but because of the practical difficulties these tend to
be 'notional" accounts, with bookkeeping entrees and few real assets. From a
6



financing point of view, notional accounts are not very different from PAYG (see
Appendix).
Another aspect of the long run problem is the fact that the vast majority
of Chinese workers, including most urban workers in nonstate enterprises, most
rural workers and all self-employed and agricultural workers are not covered by
any formal pension plan. As the extended family support system breaks down due
to the one-child policy and increased migration from farm to city, many old
people will find themselves without any means of financial security. Defined
contribution plans were recently offered to rural workers by the government on
a voluntary basis, but the small contributions made and the low (negative real)
interest rate paid imply that only a negligible annuity will be available when
these workers retire. This problem could explode in the future if preventative
action is not taken now. Extending mandatory coverage to the dynamic nonstate
sector, including the rural TVE's, in a well-structured system would enhance the
long term security of these workers--but at existing payroll tax rates might
choke off the current rapid growth rate of their enterprises.
Alternative Policy Solutions: Simple Design Change Versus Basic Reform
The remainder of this paper contrasts three alternative policy approaches
to solving the immediate SOE problem as well as the longer run problems of
population aging and incomolete coverage:
(1) continuation of pure PAYG, with design reforms such as reduced
replacement rates, use of price rather than wage indexation, increased
retirement age, and extended coverage together with expanded pools;
(2) partial prefunding of the single pillar defined benefit plan;
(3) partial prefunding in the context of a multi-pillar system which
includes two mandatory parts--a tax-financed basic benefit (Pillar I) plus
a fully funded defined contribution scheme (Pillar II).
Two sub-cases of the multi-pillar system are distinguished--one in which the
current generation of workers pays off the old pension debt (finances the
transition) through a high payroll tax; and a second in which borrowing spreads
this burden over many generations.
These alternative policy solutions imply different time patterns of
required contribution rates, which is one focus of this paper. The time pattern
of contribution rates has an efficiency dimension: If the distortionary effect
7



of higher taxes depends on the square of the tax rate, then tax rates that are
uneven over time may increase the total distortionary impact on labor supply, its
allocation to the informal versus the formal sectors, and the degree of evasion.
The pattern of tax rates over time also has a bearing on intergenerational
equity: If one believes that each generation should pay equivalent tax rates for
equivalent benefit rates, tax smoothing is equitable, while if one believes that
wealthier generations should pay a progressively higher tax burden and should
face negative redistributions, one would probably want a rising tax burden over
time. But viewed from the perspective of procedural fairness, one might argue
that the present generation should not impose an increasing tax burden on future
generations, who are not around to fend for themselves. Finally, very high tax
rates may simply not be politically acceptable, and may imply that benefit
promises will be broken in the future.
Simulations show that, while the simple design reforms slow down the rise
in required contribution rate substantially, in the long run under PAYG
population aging dominates, implying high dependency and cost rates and a large
pension debt from which it will be even more difficult to escape. In contrast,
the shift to a multi-pillar system is not economically or politically feasible
in the short run if the current generation has to pay the full transition costs,
which raises their contribution rates substantially.
However, if the design changes are accompanied by a transition to a multi-
pillar system that is financed by borrowing, both the short run and long run
peaks of required tax rates are avoided. Initially the payments to current
pensioners are debt financed, but as these pensioners die off the debt is repaid
out of taxes or SOE assets. As one solution: A payroll tax rate of 17.4%, carried
between 1995 and 2100, is sufficient to fully finance the basic benefit (7.3%),
the individual accounts (8.5%) and the pay-off of the existing debt to current
pensioners and older workers (1.6t), while yielding an expected long run pension
benefit that is 60 percent of the average wage in the economy or 55 percent of
the final year's wage for the average member of the retiring cohort. It also
builds up a large stock of long term saving for productive investment. China's
high growth rate, when combined with price rather than wage indexation, plus the
possibility of extended pension coverage, yield a financial surplus in the short
8



run that can be transformed into a long run benefit via this shift to a preferred
pension system.
III. Effect. of A. Continued and Reformed PAYG System
This section analyses the impact of a continued PAYG system on the level
and time pattern of pension system costs, given China's demographic and economic
projections.   Design reforms considered are a reduced replacement rate,  an
increased retirement age, and a shift to price rather than wage indexation--all
of which help, but not enough. These results also apply to a pure notional
account system, which is similar to the system that some Chinese cities are now
using (see Appendix). The impact of partially funding this defined benefit plan
is also considered.
Basic AsSumDtions
For pension planning very long time horizons are essential, both at the
individual and economy-wide levels. From the time a worker enters the labor force
and begins retirement planning to the time he or she dies and stops collecting
a pension, a period of 70 or more years may elapse. If individuals do not plan
ahead for this long period, they may find themselves with insufficient resources
at the end of life.
At the societal level it is very difficult to change old age policies
abruptly, because existing policies have been built into peoples' expectations
and plans. In particular, it is difficult to change expenditures on cohorts that
have already retired. For example, the legal retirement age can only be raised
gradually, the increase only applies to newly retiring cohorts, and pension
benefits are rarely reduced after retirement except through inflation and
indexation methods. Thus, policies can have very different effects on costs over
the long and short run; to get a full picture it is necessary to simulate
alternative pension systems over a period lasting 100 years or more--in this
paper until 2100--albeit recognizing that forecasts of the basic economic and
demographic environment becomtte less reliable as we go out further in time.
9



For these simulations we start with World Bank population projections for
China, 1995-2100.1 Our baseline and alternative assumptions about the rate of
real wage growth, interest rate and other economic and policy parameters over
this period are given in Table 2 . In most countries the interest rate tends to
exceed the rate of wage growth by more than 2%, over long periods. But in China
the opposite is true at present. China's rate of real wage growth over the past
decade has been almost 6% annually, while the real interest rate available to
domestic savers in recent years has been negative, due to controlled nominal
rates that are less than the inflation rate (1994 Statistical Yearbook of China,
Beijing: State Statistical Bureau). In our baseline simulations we accordingly
use a rate of wage growth that exceeds the interest rate initially and vice versa
after 2011, assuming that financial markets have been reformed and wage growth
has slowed down in the interim. We also carry out sensitivity analysis to these
variables by experimenting with scenarios in which wage growth is lower and
financial market reform faster or slower.2
The continuation of current evasion and exemption rates of 25% are also
assumed. Enforcement techniques will probably improve in the future, reducing
these leakages, but the expansion of the nonstate and informal sectors will have
the opposite effect, so as a baseline the continuation of the 25% noncompliance
rate is probably not unreasonable. It is also modest by comparison with other low
and middle income countries, where workers often qualify for benefits despite the
fact that their enterprises have not paid the full contributions; this raises the
break-even contribution rate, possibly inducing greater evasion. Obviously, if
China is able to reduce its noncompliance rate, this would correspondingly
improve the financial situation of its pension system. One of the best ways to
do so is to choose a system that costs less and reduces incentives to evade.
1 These projections assume increasing life expectancy, while the Chinese
have used projections which do not take this into account. Therefore, our data
show a continuing increase in the demographic dependency rate (Table 1) while the
Chinese data imply a levelling off after 2030.
2 In addition to the economy-wide wage growth, which is uniform for all
cohorts, we assume that for the first 30 years of working life the worker
receives a wage increase for experience and on-the-job training of 1% per year.
While age-earnings profiles have been realtively flat in China in the past, they
will probably become steeper in the future, as the transition to a market economy
proceeds. Thus the average wage of the retiring cohort will be higher than the
average economy-wide wage. The same pension amount will then yield a lower
proportion of final year's wage (called the replacement rate) than of the
economy-wide wage (herein called the benefit rate).
10



Another method is to choose a system, such as a multi-pillar system with a
defined contribution component, whose costs and financial sustainability are less
sensitive to evasion rates, as illustrated in this paper.
The urban share of the population is 27%, rural workers are not in any
mandatory system, and civil servants are in a separate scheme not included in
this analysis, so only 20% of all workers are covered in the baseline scenario.
In an alternative scenario, urban in-migration, rural industry and coverage
increase. This raises the urban share of workers to 46%, the share in cities plus
rural industry to 84% and the total coverage rate to 63% by 2050 .3
It is difficult to capture the parameters of the current Chinese system
since each city has a somewhat different program and the picture presented by the
data is sometimes different from the stated plan. As an approximation of China's
current system we use a PAYG defined benefit system with an average pension for
new retirees that is 80% of the average wage in the economy and replaces 73% of
the final year's salary (see footnote 2), indexation to prices plus 50% of real
wages (herein called 50% real wage indexation), and retirement at age 55 for
women,  60 for men.4 These parameters are changed in the reform scenarios.
Differences across municipalities and provinces are ignored.
Survivors' insurance is assumed to take its current form--75% of the normal
pension for one year only. Disability annuities are assumed to be provided at
half the normal retirement replacement rate. Early retirement benefits are 75%
of the normal replacement rate.   Administrative costs are a modest  3% of
expenditures in the existing PAYG system and 3% of revenues in the individual
3 In these calculations, "urban" means current cities. Additionally, many
currently rural areas will become "urbanized" through growth in density and
industry. Urban migration in these simulations apply only to workers under age
35. This means that, although the migration is assumed to come to an end in 2050,
the urban share continues to increase to 2100 and beyond because of population
maturation--the death of cohorts that did not experience in-migration, and their
replacement by cohorts that did migrate. Since population growth is projected to
become negligible after 2050, the continued growth in urban population implies
a small decline in rural population. See Table 1.
4 National officials claim they want to reduce the benefit rate below 80%,
but data suggest that the average pension has been about 80t of the average wage
over the last few years. The normal retirement age has been 60 for men, 55 for
women, but this simply gives us a probability distribution of retirement ages
since many workers retire earlier or work later. The inflation adjustment has
been tied to nominal rather than real wage growth, on an ad hoc basis in the
past, but is gradually becoming systematized. Depending on the relative size of
the real wage increase versus the inflationary increase, nominal wage indexation
of 40-80% may imply that pensions are going up faster or slower than prices; we
use 50% real wage indexation as a baseline. See footnote 7 for more details about
inflation adjustment.
11



accounts of the new multi-pillar system (that do not yet have expenditures);
actual administrative costs are unknown but are probably much higher, thereby
raising the required contribution rate. These ratios are retained throughout this
analysis.
Cost of the PAYG System Under Alternative Reforms
Table 3 compares the annual break-even contribution rates of the current
system and several reform scenarios, all retaining the PAYG defined benefit
format. The break-even contribution rate is the payroll tax rate that will just
balance revenues and expenditures on a year-to-year basis, given the covered wage
base and existing defined benefit formula.
Table 4, column 1, presents, for the same scenarios, the uniform or time-
invariant contribution rate that would balance the system for the entire period,
1996-2100, instead of permitting the rate to change annually. It may be that 2100
is an overly-long time horizon, given that uncertainty about the underlying
parameters increases as we move further into the future. Therefore, columns 2 and
3 show the two uniform rates that would balance the system separately for 1996-
2150 and 2151-2100. The rate for the second half of the century is always higher
than that for the first half, because the dependency rate rises through time--
suggesting that a cut-off of 2050 is deceptive unless one makes some estimate
about what lies around the corner.
The time invariant contribution rate, whether to 2050 or 2100 or some other
year, implies that funds will be accumulated during the early part of the period
and used up in the latter part--that is, the system becomes partially pre-funded
instead of pure PAYG. This in turn raises the question of whether the funds will
be managed to maximize the rate of return--a topic that will be discussed in Part
III. In Part II we simply use the uniform contribution rate as a concise way to
compare the long run costs of different reform scenarios in a single-pillar
system, taking the interest rate as given.
The current system. Table 3, row 1, shows the break-even contribution rates
that would be needed for the current system, given China's demographics and high
labor force participation rate. In this baseline scenario, break-even
contribution rates rise from 20% in 1995 to 37% in 2030, 49% in 2050 and 60% in
2100. If China chose to partially pre-fund the present system, the uniform
contribution rate that would cover all costs until 2100 is 44% (Table 4, row 1,
12



column 1). If the contribution rate rose instead to 32t, this would carry China
to 2050 (column 2), but for the second half of the century the required rate
would jump to 55% (column 3).
Required contribution rates are even higher under the slow grow scenario
(row 2) , since revenues decrease commensurately with wage growth but expenditures
decrease at a lesser rate (because pensions are only partially indexed to wages).
If the high payroll tax is borne by workers, this high contribution rate means
much lower take-home pay than they would otherwise get. If borne by employers,
it means less competitiveness on international markets and more unemployment. In
either case it means that the current generation of pensioners has gotten a
bargain for which future generations pay a very high price.
Rows 3-6 retain the PAYG financing method and baseline scenario but add
alternative policy reforms. Row 3 reduces the benefit rate to 60% and the
replacement rate to 55% for new retirees; row 4 increases the retirement age (4
months per year for women until 60 is reached in 2010, then 2 months per year for
both men and women until 65 is reached in 2040)5; rows 5 and 6 impose price
instead of 50- real wage indexation; and rows 7 and 8 assume rapid or delayed
financial market reform, respectively. Finally, row 9 shows the impact of all
these policy reforms if undertaken simultaneously under PAYG and row 10 shows the
combined impact when coverage is extended to increased urban migrants and to
rural workers who have shifted out of agriculture into TVE's and private
companies.
Benefit rate and retirement age: the high cost of early retirement. China's
replacement rate is very high by international standards and its retirement age
is low, hence its expected duration of retirement of 19 years is also high
compared with other countries. If the retirement age is not raised, the duration
of retirement will jump to 25 years by 2050, given life expectancy projections
(Table 1). Reforming these two design features has a powerful downward effect
on costs, especially in the long run. The uniform contribution rate to 2100 is
cut 10 percentage points, one quarter of total cost, for each of these reforms.
' Some Chinese workers retire under special early retirement programs. In
these simulations we assume these programs continue to exist in their present
form when the normal retirement age increases. It is possible, on the one hand,
that the allowable early retirement age will rise if the normal retirement age
increases. On the other hand, it is also possible that more people will find some
way to get early retirement if the normal age rises. These simulations assume
unchanged early retirement propensities.
13



If the uniform rate iB allowed to change in 2051, it is cut 6-7 percentage points
for the first half of the century, but much more--5.4-18 percentage points--for
the second half (Tables 3 and 4, rows 1, 3 and 4, respectively).
Figure . shows the trade-off between retirement age and contribution rate,
holding benefit rate constant at 60%, and Figure 2 shows the trade-off between
retirement age and benefit rate, holding contribution rate constant.6 A gradual
rise in retirement age from 60 to 70 for men and women reduces the break-even
contribution rate by 1-2 percentage points per year of increase (Figure 1). A
gradual rise in retirement age (holding contribution rate constant) raises the
feasible benefit rate by 3-4 percentage points per year of increase (Figure 2).
The increase in retirement age has a double impact--reducing lifetime
payouts while increasing lifetime contributions. Since raising the retirement age
is a sensitive issue in many countries, including China, it is important for them
to be aware of this high opportunity cost. Indeed, many countries want to reduce
the retirement age to reduce unemployment--and China also encouraged people to
retire early when shedding labor from SOE's. But actually, early retirement only
hides true unemployment--which may be attractive politically but is costly
economically. Pensions are more expensive and last for a much longer time period
than unemployment benefits, hence require a higher payroll tax that raises labor
costs. Retired persons are less likely to look for jobs than unemployed workers.
For both reasons, an early retirement age may lead to a lower level of employment
and output. Instituting a higher retirement age to increase the supply of labor
will be particularly valuable after 2030, when the working age population
contracts due to population aging--but to have it in place then, the process must
begin soon.
Price versus wage indexation. Only the shift from 50% real wage to price
indexation affects current pensioners, and this saves an additional 6 percentage
points in the long run (row 5) . Price indexation maintains the absolute
purchasing power of the pension, while wage indexation maintains its value
6 In these figures, it is assumed that the retirement age for women has been
raised to 60 by 2010, and the increase in retirement age depicted takes place at
the rate of 4 months per year, starting in 2011, for both men and women. The
benefit rate is held constant at 60% in Figure 1 and starts at 60% in Figure 2.
The break-even contribution rate, of course, changes over time. In Figure 2, the
contribution rate is held constant in the year 2050 and in Figure 1 we report the
changes that occur in 2050, at which time all the effects of the raised
retirement age should be observed.
14



relative to the average wage in the economy. If real wages were growing slowly,
say at 1t annually, as in many OECD countries, the savings from price indexation
would be much smaller (compare rows 2 and 6). China, with its expected high
growth rate, is well positioned to achieve substantial cost saving from price
rather than wage indexation.
However, the cost of this saving is the deteriorating position of retirees
relative to workers: if the real wage growth rate is 5.5% and price indexation
is used, the retiree who started with a benefit that was 80% of the average wage
gets only 40% of the new average wage after 13 years, and only 21% after 25
years.  In contrast,  under  50% real wage  indexation,  the relative pension
deteriorates much slower--to 41% of the average wage after 25 years--but this
indexation method costs more, as we saw above (Figure 3).
For a given cost, China faces a key trade-off between the relative well-
being of young versus old retirees, through the selection of indexation method.
For example, holding the (2050) contribution rate constant, China could choose
an 80% benefit rate combined with price indexation, or a 69% benefit rate
combined with 50% real wage indexation. This trade-off is depicted in Figure 4,
which shows that pensions are initially higher with price indexation, but the
very old are better off with real wage indexation. The best choice for China and
other countries depends on how much pensioners value income in their early years
of retirement relative to that in their later years, and whether they care mainly
about the absolute value of their purchasing power or their position relative to
workers7.
Financial market reform. Currently interest rates are controlled and, for
domestic savers, are very low (even negative in real terms) in China. In
addition, types of financial instruments available are limited. Financial market
reform which would include increased diversification in instruments, greater
freedom for private financial institutions, and liberalized interest rates, is
important for China's continued development.
7 The actual system in China is sornewhat different from either pure price
or wage indexation, in many cities. After an aggregate inflation adjustment
amount is determined, usually based on nominal wage increases, this is often
distributed on a flat basis to all pensioners, rather than being prorated
according to their pensions. Recent retirees with relatively high wages and
pensions may thus get less than price indexation would dictate while older
cohorts may get more--another way to reduce disparities in relative well-being
among cohorts.
15



Here we simply test the impact of interest rate reform on the financial
sustainability of the pension system. In general, the interest rate has no effect
on the annual break-even contribution rates in a PAYG system, since revenues and
expenditures, by definition, balance every year and do not earn an investment
return. But once partial funding is introduced, the interest rate can make a
difference.
It turns out that speeding up financial reform, so that the real interest
rate is 3% instead of 0 between 1996 and 2010, has only a small effect, reducing
the uniform contribution rate by less than 1 percentage point (row 7). Pension
reserves are very small at this point, so the interest rate is relatively
unimportant. (See Table 8 and discussion below) . On the other hand, delaying the
financial market reform and depressing interest rates beyond 2011, when reserves
have become larger, -aises the required contribution rate substantially (row 8).
Thus, China has a breathing spell, but if it does not act within this period, its
problems will grow.
Combined reforms and coverage expansion.   These combined reforms--an
increase in the interest rate, a decrease in the benefit rate to 60% and the
replacement rate to 55%, an increase of the retirement age to 65 and a shift to
price indexation- -do indeed reduce expenditures substantially. Both annual break-
even rates and the uniform contribution rate eventually fall to half their
initial (unreformed) values. Nevertheless, population aging causes the annual
break-even contribution rate to exceed 20% by 2030; it reaches 27% and is still
rising in 2100 (row 9).
One method that many countries have used to keep their PAYG systems afloat
is to gradually expand coverage, together with broader pooling to unify rates.
This method is especially tempting in China, where only 20% of the total labor
force is now covered and where pension expenditures are less than 2% of GDP (as
compared with 10-15% in most European countries).
Rural workers will increasingly move to the cities as mobility restrictions
are lifted, most of these will enter the nonstate sector, and those remaining in
the countryside will move out of agriculture into TVE's and private companies
where enforcement of contributions to a formal mandatory system is more feasible.
The pros and cons of covering these groups are discussed in Part III. Here we
simply assess the impact on system costs. As young workers from newly covered
16



groups enter the system, this reduces the dependency rate and break-even payroll
tax rate initially, because these groups are contributing but do not yet have
eligible retirees. However eventually, as coverage expansion comes to an end and
the newly covered workers receive pensions, the required contribution rate rises
sharply.
This process is demonstrated in row 10, which assumes that migration of
rural workers to the cities and coverage of rural workers is expanded (as
detailed in Table 2) . Reduced replacement rates, price indexation, increased
retirement age and financial rnarket reform are also assumed, enabling comparison
with row 9. We see that coverage expansion does indeed depress the break-even
contribution rate still further, but its effect is concentrated in the early
years. Once coverage expansion slows down, annual break-even contribution rates
rise steeply and almost converge with those for the system without coverage
expansion. Only pre-funding, a move to a more uniform contribution rate, can stop
this process.
Thus coverage expansion as a solution to the problem of population aging
is deceptive and dangerous if the PAYG system is retained because it may lull
countries into complacency, but the problem eventually reappears, in a more
intractable and socially divisive form. That is, the pension debt, which is
relatively small at present, expands together with coverage, limiting the choices
that will be open to China later on. The transition to a partially funded system
is much more feasible for China at present, before coverage expansion has taken
place.
IV. Partial Funding in a Multi-Pillar System
China is interested in shifting to a partially funded system to eliminate
the negative effects of the high future tax rates that would be implied by a pure
PAYG system. A partially funded system also has a positive advantage: it helps
to build up a stock of retirement savings that can be used to develop financial
markets and can be channelled through these markets to finance long term
investments--both of which will enhance China's economic growth. Whether these
results will be achieved depends in large part on how the funds are managed and
allocated. The first part of this section discusses this issue.
17



While recognizing the advantages of prefunding, most Chinese municipalities
have been unable to achieve it so far, because of the heavy burden of current
pension obligations. The second part of this section describes how a transition
to a partially funded multi-pillar system can be made, using a combination of
borrowing, taxes, sale of SOE assets, and coverage extension.
The Rationale for a Multi-Pillar System
The simplest way to achieve partial funding and smooth contribution rates
over time is to maintain the defined benefit structure and simply build up a
reserve fund to meet future needs. Many countries have attempted to use this
method, but few have succeeded. The results of this method, if it worked well,
have been shown in Table 4. Rows 9 and 10 seem to imply that if China reformed
its system by design changes, using the proceeds to build a reserve, it could
live with a contribution rate of less than 20% well into the twenty first
century. Unfortunately, in other countries partially funded defined benefit
systems, with the reserves centrally managed, have not worked well, because of
upward pressures on expenditures and downward pressures on returns from
investments and growth. For the calculations in Table 4 pension benefits,
investment returns and wage growth were taken as exogenously given, but evidence
from other countries indicates that choice of system impacts the ability to
constrain benefits and expand revenues.
One problem that frequently develops in partially funded defined benefit
systems is the likelihood of continued pressure to raise the promised benefit
level, if a reserve fund does develop. Even if design reforms such as a reduced
replacement rate are put in place initially, they may not last if politicians
cannot withstand these  pressures.  In particular, policy-makers may find it
difficult to raise the retirement age as longevity increases, if reserves have
accumulated; this could potentially be a problem in China. So in the end the
funds disappear.
A more central problem is that under the present structure government
control over the investments of the funds would be needed, since ultimately
governments (in China's case, local governments) have the obligation to pay the
defined benefits. But the experience of many countries suggests that publicly
managed funds are likely to pursue political rather than economic objectives and
therefore do not maximize the returns to the funds or the productivity of
18



capital. For example, during the 1980's centrally managed pension funds in many
countries lost money because they were required to invest primarily in government
bonds or in loans to failing state enterprises, at low nominal interest rates
that became negative when inflation rose (World Bank 1994).
We observe a similar phenomenon in China today. Currently those pension
reserves that do accumulate are managed by municipal authorities, although the
central government requires them to invest mainly in government bonds and short
term bank deposits. Interest rates are controlled by the central government and
in recent years the rate of return has been negative--less than the rate of
inflation and far below the rate of wage growth. It is unclear whether local
authorities actually follow these rules; monitoring is difficult and incomplete.
But other problems arise with those funds that are invested at the discretion of
the municipal authorities: they are all retained locally, sometimes lent to
failing SOE's. Not only is international diversification prohibited, even
investments beyond the municipality are unlikely to be chosen. And no competitive
mechanism exists to encourage capital mobility that would maximize returns and
social productivity, or to diminish the role of those municipalities that are
doing a poor job.
Closely related are other dangers that could arise when governments have
exclusive access to publicly managed pension funds. The nontransparency of this
arrangement may induce them to spend wastefully or to use excessive deficit
finance. If part of the funds are invested in private securities, this raises the
specter of back-door nationalization, as the government may be in a position to
influence corporate decisions and the access of different enterprises to
financial resources via its control over investable funds. These potential
problems, which were ignored in the simulations presented in Table 4, increase
exponentially as pension reserves grow and become a large share of the total
capital in the economy.
In contrast to publicly managed funds, privately managed pension funds
fared very well during the 1980's, because they were insulated from political
control and able to take full advantage of the high yields that were available
through a diversified portfolio of bonds, equities, real estate and foreign
assets. This empirical experience, and the behavior that lies behind it, suggests
that competitive decentralized management of funds is likely to earn a higher
19



return for the pension system and for the economy as a whole, a major reason for
choosing a multi-pillar system in which the funds are concentrated in the private
pillar.    This will  also help  to develop  financial  markets,  an essential
prerequisite for economic growth at the stage where China is now. In order to
achieve these benefits, Singapore and Malaysia, which until recently featured
central control over their pension funds, are now decentralizing, allowing
greater diversification of investments and giving workers greater control over
the investment strategy.
Besides the advantage of competitive management of pension reserves, there
is also an advantage to having part of the pension system set up as defined
contribution rather than defined benefit. The hidden, sometimes perverse
redistributions that are inherent in defined benefit plans are thereby avoided.
The close link between benefits and contributions, both en toto and at the
margin, means that workers are more likely to regard the required contribution
as their own saving, rather than a tax, hence it is less likely to reduce
employment or induce evasion. And the evasion that remains does not undermine the
financial viability of the system, as it would in a PAYG defined benefit plan.
This paper does not quantify the reduction in evasion but it does quantify the
financial improvement for the system when the evading individual bears the cost.
In addition, defined contribution plans automatically avoid higher costs
as longevity increases, without the politically difficult decision to raise the
retirement age periodically- Instead, either the retirement age shifts upward or
the annual benefit shifts downward automatically when the worker's accumulation
is converted into an annuity upon retirement, as life expectancy rises.
Similarly, policy-makers need not make a universal choice between wage and price
indexation as real wages rise, since each worker can choose a different time
profile of consumption. Those who want their living standards to keep pace with
wages will have to forego withdrawals at the beginning of retirement rather than
placing a financial burden on the over-all system. (See World Bank 1994 for a
fuller description of and rationale for this multi-pillar system).
For all these reasons, the uniform contribution rates given in Table 4--
which are based on a partial equilibrium model with many variables treated as
exogenous that are in fact endogenous--underestimate the real values that would
be needed in a single-pillar partially funded defined benefit publicly managed
20



system. This paper explores the situation in which partial funding is implemented
through a multi-pillar system in which the funded and unfunded parts (or pillars)
are separated, each mandatory and each having different objectives and managerial
arrangements.
The unfunded or tax-financed pillar provides a defined benefit, has the
object of providing a social safety net, and is controlled by the government,
which has the power to redistribute. Having a straightforward poverty-prevention
goal, this pillar is more likely to achieve it than under current single-pillar
systems, where poverty-alleviation is but one of several competing goals, many
kinds of redistributions go on, and they are difficult to observe and measure
(see World Bank 1994 for empirical evidence on the experience of single-pillar
systems).
The funded part, in contrast, is privately managed and set up as a defined
contribution plan. The investment managers may be chosen by workers (Chile and
Argentina) , employers (Switzerland) or joint union-employer boards (Australia).
Given the absence of independent unions, the fact that many employers are state
enterprises, and the importance of facilitating labor mobility, the former is
probably the best course in China today. This pillar is ideally suited for
maximizing the rate of return on peoples' retirement saving.
Specifically, these two pillars take the following forms in this paper:
1) a basic benefit ( 25% of the local average wage)--designed to keep the
old out of poverty, and financed out of broad payroll or general tax
revenues (Pillar I); and
2) a defined contribution (8.5% of wages) that goes into individual
accounts--fully funded, invested competitively by managers who are chosen
by the workers themselves, and eventually turned into an annuity or
gradual withdrawals upon the worker's retirement (Pillar II) ."
One of the biggest risks of pension reform in China is the probable resistance
from local and central governments toward private competitive management of
pension funds--in which case many of the supposed benefits may be lost.
Risk in the Single-Pillar and Multi-Pillar Systems
8 The flat benefit might be pro-rated by years of covered service, at the
rate of, say, .6% per year. Prorating would not change the results of these
simulations, so long as the average benefit remained 25% of the local average
wage. The organization and regulation of the investment management of the defined
contribution pillar are discussed generically in World Bank 1994.
21



Pillar I, by definition, provides a basic benefit that is 25% of the local
average wage or 23% of the final wage of the average member of the retiring
cohort. Under the real wage growth and interest rate conditions assumed in this
paper, Pillar II will yield a 32% replacement rate of final year's salary for an
individual who retires after 45 years of contributions, has an expected
retirement duration of 19 years, and chooses a price-indexed annuity (see Table
5). Thus, under these conditions, the expected pension for the average worker
from the two pillars together, in the long run, is 60% of the economy-wide
average wage or 55% of final year salary, the same as the reformed replacement
rate in the PAYG system analyzed in Part II.'
But the variance of the benefit in the multi-pillar system differs from
that of the defined benefit in the PAYG system in at least two important
respects. First, the provisicn of a basic benefit that depends on local average
wage rather than the worker's own wage means that the replacement rate from the
first pillar varies among workers from, say, 46% for a low income worker who
earns half the average wage, to 11% for a high income worker who earns twice the
average wage, and this means that the total replacement rate varies from 78% to
43t. Thus, a worker does not know ahead of time what his own replacement rate
will be. This variance in the replacement rate increases uncertainty in one
respect, but it simultaneously reduces the risk of poverty for low wage workers.
A basic benefit of this sort could be build into the defined benefit formula, but
often it is not and the non-transparency of the formula makes it difficult to
calculate the true distributional effects.
Second, the interest rate plays an important role in the funded individual
accounts that it did not play in the PAYG system--if it falls so too will the
replacement rate and if it does not exceed the growth rate of wages the system
is unlikely to produce an acceptable pension benefit. For example, if the
financial market reform were delayed so that the interest rate after 2010 was 1%
instead of 4%, the replacement rate for the average worker from the defined
' The replacement rate would be less for a worker who enters the system
before 2010 because during 1996-2010 the interest rate is assumed to be less than
the wage growth rate. For instance, a worker who enters in 1995 and retires in
2040 only gets a 53% replacement rate and therefore a lower rate of return. If
the lower interest rate continues for longer, so too would the lower replacement
rate. This is an example of the fact that both the wage growth rate and the
interest rate determine the pension in a defined contribution account, and the
worker is therefore subject to interest rate risk.
22



contribution pillar would be 13% instead of 32%. To bring the replacement rate
back to 32% would require a contribution rate to Pillar II of 20% instead of
8.5%. Interest rate risk is inherent in funded defined contribution systems,
underscoring the importance of using financial institutions and instruments that
produce high returns.
In a pure funded defined contribution plan, the worker is subject to
capital market volatility and in a pure PAYG defined benefit plan the worker is
subject to political risk--the possibility that the government will be unable to
keep its pension promises. Compared with a single-pillar plan, the multi-pillar
system has the advantage of diversification and consequent risk minimization,
since the total pension depends on a combination of sources--partly on payroll
taxes and partly on income from capital, partly on private sector capacity and
partly on public sector credibility, partly on domestic economic developments and
partly on the broader international situation (through investments abroad). If
one basket breaks, hopefully some eggs will still be left in the other basket.
The Cost of the Multi-Pillar System, And How to Finance the Transition
Although a shift from the current PAYG defined benefit system to a
partially funded multi-pillar system may be desirable for all the reasons given
above, it involves transition costs, because the old pension debt must be paid
off (i.e. existing pensioners and new retirees must continue to receive their
benefits), while at the same time workers are contributing enough to build up
their own individual accounts. The payments to existing pensioners can be
financed by payroll, income or consumption taxes, by cuts in other government
expenditures, by proceeds from the assets of privatized state enterprises, or by
borrowing. How these transition costs are covered determines the time pattern of
required contribution rates under the new system, as well as its efficiency and
equity effects.
The "double" costs that appear to be involved during the transition have
been a major stumbling block to reform in many countries--they appear to impose
a huge tax burden (or service cut) on the current generation of workers. However,
this concentrated double cost for the transition generation turns out to be an
illusion, since the possibility exists of borrowing and spreading the burden of
repayment over several generations, at a low cost to each. In this section we
23



compare the costs of the new system, including the transition, with and without
borrowing, under the assumptions that:
*In 1995, China shifted to the multi-pillar system just described, i.e. new
entrants to the covered labor force simply receive the basic benefit and the
annuity from their own accounts.
*The pay-off of the pension debt is financed through a transition account.
Current pensioners continue receiving their stated benefits and "middlemen,"
i.e., current workers, will receive a compensatory annuity that is 1% of their
final year's salary for each year of service under the old system (in addition
to the basic benefit and an annuity from their individual accounts).
*To reduce program costs, retirement age will gradually be raised to 65 and
price indexation will be used, as in the reform scenarios discussed in part II.
*In the baseline scenario coverage does not expand but in later scenarios
it does.
Transition costs paid by present worker cohorts. In this scenario there is
no borrowing and no coverage expansion. Instead, current workers pay the costs
of the new system (which includes their own prefunded accounts) and also cover
the obligations to pensioners and middlemen under the old system (Table 6, row
1) . The latter requires a payroll tax of 20% initially, but this declines to 3%
by 2030 and 1% by 2050 because most of the middlemen have died and the remaining
few get compensation for only a small number of years under the old system.
Comparing the total cost of this reformed multi-pillar system with a continued
but reformed PAYG system (Table 3, row 9), we see that initially required
contribution rates are 8.5 percentage points higher under the multi-pillar system
than under PAYG--but by 2100 the former is 7.5 percentage points lower. While
payroll taxes rise through time under PAYG, they fall under a multi-pillar system
if the current generation finances the transition. Neither model provides tax
smoothing over time. Nor is the high initial rate under prefunding likely to be
economically desirable or politically acceptable.
Transition costs spread over many generations through borrowing.
Alternatively, a uniform contribution rate over time can be charged that will
just cover the debt of the old system as well as the costs of the new system
until 2100 (Table 7) . Without extended coverage, this rate turns out to be almost
20W. This can be decomposed into 1) a 3.7% payroll tax that pays off the pension
24



debt, 2) an 7.5% payroll tax that equates the present value of revenues to the
present value of expenditures for the basic benefit (Pillar I), and 3) an 8.5%
defined contribution to the individual accounts in Pillar II.
Initially transitional expenditures are much greater than the 3. 7% uniform
payroll tax so money must be borrowed to cover some of the payouts to existing
pensioners. But transiticr. costs disappear shortly after 2050 as payments to
middlemen decline, and the loans are fully repaid by 2100, out of the continuing
payroll tax. Thus, the combined uniform rate (with borrowing) is lower than the
year-to-year rate on row 1 (no borrowing) at first, but slightly higher later on.
The loans to the transition account would come first from the surplus in
Pillar I and second from the financial markets more broadly. One possible source
of loans is Pillar II, which would make the pension system as a whole self-
sustaining. While Pillar II remains autonomous and competitive, so it is not
required to lend for this purpose, lending to the government to finance the
transition is a logical investment strategy at the start given the limited number
of financial  instruments available.  These loans would be explicit,  with a
specified redemption date and a positive market interest rate  (unlike the
notional individual accounts discussed in the Appendix). They could be guaranteed
by the government and/or collateralized by future earmarked payroll taxes or
proceeds from SOE assets (see below) . A plan for repaying the loans is important
if part of the object of the pension reform is to increase national saving. This
financing method, based on borrowing and eventual repayment, implies that the
burden of the transition is spread over 105 years of cohorts, instead of being
borne heavily by the first 30 years of cohorts.
Extended coverage and broader pooling. The temporary gains from coverage
expansion to the nonstate sector in urban and rural areas can ideally be used to
finance the transition to a partially funded system, whose costs are also
temporary. If we expand coverage, the constant contribution rate needed to
finance the new system plus the transition falls to 17.4% (Table 7, row 4) . This
again can be decomposed into three parts: 1.6 percentage points needed to pay off
the pension debt (the transition account), 7.3 percentage points used to pay the
on-going costs of the basic benefit CPillar I), and 8.5 percentage points for the
25



individual accounts (Pillar II). (Alternatively, the pension debt can be paid
off by 2050 with a 2.8% contribution rate)."
The gains from coverage expansion are concentrated in the first three
decades, exactly when the transition costs are at their highest (Figure 5) . The
contributions of newly covered workers to Pillar I in effect are used as a timely
loan to the transition account in the early years when it is running a deficit,
and the repayment of the loan when it has a surplus is used to cover their
benefits from Pillar I later on (Table 8, row 4). This reduces the loans that
would be required from elsewhere in the economy.
Without coverage extension the transition account plus Pillar I,
combined, run a large debt until 2050 and the balance does not become zero until
2100 even though a higher contribution rate is charged (Table 8, rows 2 and 3).
The debt must be covered by continued borrowing from Pillar II or other lenders,
thereby using up financial resources that could be invested productively
elsewhere. In contrast, when coverage is expanded the larger base of contributors
augments revenues long before it increases expenditures of Pillar I, so that the
combined debt is eliminated by 2015 and becomes small even earlier (rows 5 and
6) . Thus, the entire balance in Pillar II can be used to increase the productive
capacity of the economy. And this balance in Pillar II becomes mauch larger with
increased coverage.
To achieve these financial gains from coverage expansion, it must go hand-
in-hand with broader pooling for paying the transitional costs and the basic
benefit, to ensure that the newly covered groups are not in their own separate
pools. (Pillar II, in contrast, should remain decentralized and competitive) . For
example, pooling might take place at the provincial rather than the municipal
level. The current system of local pooling is due in part to administrative
factors such as the localization of tax collection facilities and the payment of
benefits in cash (since checks do not exist and electronic transfers are only
just beginning in China). From the viewpoint of economic efficiency, one would
'° If a decision is made to pay off the pension debt by 2050 and to balance
the system separately for the periods before and after 2050, this would require
a 17% contribution rate before 2050 (3% for the transition account, 5.5% for
Pillar I and 8.5% for Pillar II) and 19% (10.5% for Pillar I, 8.5% for Pillar II)
after. The higher cost of the basic benefit in the latter period due to system
maturation and the increased dependency rate offsets the concentrated transition
cost in the first period, so the contribution rate turns out to be very similar
for the two periods.
26



expect the locus of the pool to expand, and eventually to become national in
scope, as the benefit-disbursement, tax-collecting and record-keeping capacities
of the provinces and the central government improve. Besides facilitating the
financing of the system, this will also maximize economies of scale from broader
risk-sharing and computerized administration. But the process of centralizing
Pillar I may be delayed by political considerations, including the limited
capacity of the provinces and central government to secure compliance from
localities that wish to control the reserves and those with low dependency ratios
who will lose if forced into a common pool.
Aside from the financial advantage to the pension system and the economy,
the newly covered groups also benefit by receiving protection when they grow old,
if the family support system has broken down in the interim. But the danger of
covering these new enterprises is that they may resist by evading and if they
don't evade their labor costs will rise, partially choking off their growth. If
the contribution rate is kept low, and in a form that is closely linked to
benefits so that workers consider it their own savings rather than a tax (as in
a multi-pillar system with a defined contribution component), this negative
effect will be minimized.
Comparisons among alternative systems. In summary, Figure 6 contrasts the
stream of break-even contribution rates that would be required under the current
PAYG system, the reformed PAYG, and the reformed multi-pillar system with
coverage expansion but without initial borrowing (lines 1, 2 and 3). The first
is obviously much higher than the last two, demonstrating that the design changes
are essential whether or not the transition is made to a multi-pillar system. The
second is lowest at first because it does not incur transition costs and the
third is lowest at the end because it is partially funded.
Figure 6 also contrasts the uniform contribution rates under a partially
funded defined benefit versus a multi-pillar system with the transition financed
through borrowing (lines 4 and 5). One might expect the required rate to be
higher in the multi-pillar, which ends up with a large stock of capital, whereas
funds in the single-pillar system are depleted by the end. Nevertheless, it turns
out that the contribution rate is one percentage point lower under the multi-
pillar system.
27



How can this be? The main explanation appears to be the high (25%) non-
compliance rate, which makes the effective tax rate much lower than it appears,
for both systems. When a 20% tax rate is imposed, only 15% of the wage bill is
collected. Under the single pillar system as well as Pillar I in the multi-pillar
system, people who evade or underreport their income often manage to collect
benefits, thereby using up resources that they never contributed. However, in the
defined contribution component the evader pays the price--he simply does not have
an account or an annuity from it at the end. Evasion costs are not passed on to
others, nor do they undermine the financial sustainability of the system. Because
contributors are not forced to subsidize evaders, the 8.5% defined contribution
rate provides a benefit to them that would have cost much more in the defined
benefit system and leaves enough left over to build a large reserve fund at the
same time. Part of these retirement savings may simply crowd out other voluntary
saving but part are a net increment to national saving, particularly long term
saving,  and  as  such augment  the  country's  capital  stock  and  GNP.    The
accumulation of these large reserves means investment income is generated that
keeps payroll taxes low even beyond 2100, while in the partially funded defined
benefit system the reserves are depleted by 2050 or 2100 and the contribution
rate will have to rise sharply.
In reality, the cost advantage of the multi-pillar system over the
partially funded defined benefit scheme is likely to be higher yet, when the
feedback effects on economic growth from the superior allocation of capital,
financial market development, reduced escape of labor to the informal sector, and
the tendency toward later retirement--that were not quantified in the present
analysis--are taken into account.
Use of SOE assets. Proceeds from the sale of state owned enterprise (SOE)
assets are an additional potential funding source for the transition--in China
and in other countries as well. SOE's and their municipalities have substantial
assets in the form of plants, equipment, housing and land use rights, in addition
to pension and other liabilities. It is tempting to use their assets to offset
their pension debt. This could be accomplished through a direct transfer of
assets or proceeds from the assets when they are sold, or indirectly by imposing
a capital gains tax on asset sales, especially housing and land use sales, and
utilizing the revenues to finance the transition.   If capital gains that are
28



realized over the next two decades represent a windfall that is due to rapid
changes in the Chinese economy rather than to calculated investment decisions,
a modest tax on these gains may be less distortionary and more equitable than an
incremental payroll tax.
In the most optimistic scenario the assets would be used to pay off the
whole pension debt. The transitional account would borrow initially, but these
loans would be fully repaid and replaced by proceeds from the SOE assets as they
become available. This strategy, if feasible, would reduce the long-run break-
even contribution rate by 1.5 percentage points, to a total of 16.5%.
More modestly, the assets could repay part of the pension debt or enable
the loans to be repaid faster, so that lower contribution rates could gradually
be phased in. The assets could also be used as collateral for the loans, thereby
making the loans more attractive. Some localities in China are already using
these assets in a minor way to help cover their pension expenses. For example,
in Luoyuan county, Fujian province, land-use transactions are taxed for this
purpose. Although rules regarding bankruptcy are not yet completely clear, they
are moving toward a situation in which payment of the pension debt will have a
high claim on the assets of bankrupt firms.
In the aggregate and in the long run the value of SOE assets far exceeds
the pension debt in China. However, many institutional and political impediments
make it difficult to count on using these assets for a direct pay-off of the
pension debt. Among these obstacles are the ambiguous ownership rights over SOE
assets (are the owners the SOE's, the municipalities or the state?) the fact that
ownership of assets and liabilities may not coincide, and the wide variance in
value and accessibility of SOE assets across municipalities. Ironically, the
more SOE's are encouraged to behave as self-sustaining enterprises rather than
as arms of the state, the less willing those with substantial good assets will
become to give them away to bail out those with few assets and a large debt.
Other difficulties stem from the absence of well developed real estate and
mortgage markets, the reluctance of long-time tenants to move or to pay market
rents, the possibility that the needs of pension policy and housing policy may
conflict, and the great uncertainty that surrounds the time at which proceeds
from SOE assets will become available.
29



If SOE's sell their housing and other assets, from an economic viewpoint
the proceeds should be used in a way that maximizes the return. In some cases,
a pay-off of the pension debt may satisfy this criterion, but in other cases
SOE's may be better off financing the pension transition through a stream of
payroll taxes, while investing the proceeds from their assets elsewhere (e.g. in
up-to-date equipment), to enhance their productive capabilities. This is
especially the case in a situation where borrowing facilities are limited.
Moreover, it is possible that privatization of SOE's will take place through
corporatizing them (issuing stock) or by converting them into joint ventures with
foreign firms. In that case, the assets would remain with the new privatized
enterprise rather than being sold and liquid funds would not be generated to pay
the pension debt. Taxing housing sales, land use transactions and stock sales of
corporatized enterprises might still work--so long as the tax rate is kept low
to avoid impeding the development of real estate and equity markets.
These various obstacles have proved insuperable in some Eastern European
countries, but others (e.g. Hungary and Poland) are indeed using SOE assets to
cover the deficits of or partially fund their old pension systems, and Bolivia
is using them to fully fund its new pension systems. In China, applying SOE
assets to help pay off the pension debt, directly or indirectly through a capital
gains tax, remains a promising possibility that should be explored--so long as
pension reform is not made contingent on this possibility. As part of such a
plan it is essential to identify a default source of revenue in case the revenue
from SOE assets does not materialize in a timely manner. As noted above, a small
payroll tax is one such default option.
IV. Conclusions and Risks
As one of the most rapidly aging countries in the world, China is
evaluating how to reform its old age support system so that it provides
protection to the old and does not impede rapid economic growth. The current PAYG
defined benefit system will not achieve either goal. It will produce contribution
rates of 40% by 2030 and over 50% by 2050, the uneven tax rates across
municipalities and enterprises interferes with efficient resource allocation, the
fragmentation and lack of funding of the scheme impede labor mobility, later
30



generations of old and young will lose real income, and the vast majority of
workers are not covered at all. Chinese authorities recognize these problems and
are experimenting with alternative reforms.
This paper has analyzed the impact of design options such as decreased
replacement rates, increased retirement ages and a move toward price rather than
wage indexation, as well as more basic changes such as a shift toward a partially
funded multi-pillar system. We conclude that:
*The design reforms described above are an essential first step and reduce
costs substantially; however, steeply rising contribution rates, inducements to
evade and intergenerational transfers remain under PAYG.
*The shift to a partially funded system would cut these tax swings and
intergenerational transfers and would help to build up a large stock of long term
saving.
OBased on the experience of other countries, private management of these
funds seems most likely to maximize their rate of return and a multi-pillar
system that includes a funded privately managed defined contribution pillar to
manage peoples' savings plus a PAYG publicly managed defined benefit pillar to
provide a social safety net seems most likely to achieve the redistributive and
replacement rate objectives at minimum costs, and with greatest diversification
of risk.
*A system that includes a defined contribution component achieves
substantial financial savings compared with the single pillar system, by making
the evader bear the cost in terms of foregone benefits. But the biggest advantage
of the multi-pillar approach may be its feedback effects on economic growth--by
reducing escape to the informal sector and early retirement and by increasing
long term saving and financial market development--which, have not been
quantified in this study.
*The transition to such a system can be accomplished with a long term
contribution rate of under 18%, considerably less than that imposed today in most
Chinese cities. Of this total, 1.6 percentage points would be used to pay off the
old pension debt, 7.3 percentage points would finance the basic benefit and 8.5
percentage points would go into the individual accounts. Such a time-invariant
contribution rate implies borrowing initially to cover deficits, as current
pensioners are paid while reserves build up, and repaying these loans with
31



surplus revenues later on. The costs of paying the pension debt are thus shared
by several generations. Some of the loans could be made by the funded pillar as
a part of its investment portfolio in the early years of the new system.
*Proceeds or taxes from the sale of SOE assets are another possible source
for financing the transition. This could cut the long run tax burden by up to 1.6
percentage points.
*The large potential for expanding coverage together with broader pooling,
is partially responsible for these affordable costs. The pay-off of the pension
debt is also facilitated by China's high wage growth rate, combined with price
rather than wage indexation of benefits, since this expands the tax base while
constraining the rise in expenditures. If China's wage rates followed the slow
growth scenario, as in OECD countries today, the requisite uniform contribution
rate would rise 3 percentage points. China is in a position to convert these
short term opportunities into long term gains--an improved, sustainable pension
system.
One risk of this scheme is that bringing the nonstate sector into the
system might choke off its rapid growth rate, which has been good for the economy
as a whole. Minimizing or counteracting this risk is the fact that expanded
coverage could be phased in gradually over a period of years, the contribution
rate would be considerably below current levels, much of it would go into
workers' own defined contribution accounts which might be less distortionary
since intra- and inter-generational redistributions are not involved, and
including all enterprises creates a level playing field which in itself enhances
efficiency.
A second risk is the possibility that many enterprises, especially those
in the nonstate sector, might try to evade contributing, and that local
authorities might not cooperate fully in enforcing compliance. Because these
policies involve extension of coverage to groups that are not now in the system
and they alter the pattern of costs and benefits among those in the system, some
people may regard themselves as winners and some as losers from the change. In
principle it should be possible to make most groups better off if there are true
efficiency gains. Some of the gains are: an impediment to continued high growth
rates will be removed; all workers will get more secure pensions in the long run;
previously covered groups will benefit from lower contribution rates and
32



especially from lower rates than they would have had to pay in the future; newly
covered workers will benefit from pensions when they retire, thereby heading off
potentially serious social problems; newly covered employers might pay their
share of the contribution rate in lieu of wage increases--particularly feasible
in a context where wages are rising rapidly; and workers and/or municipalities
will get greater discretion regarding the investment of funds in the individual
accounts. Nevertheless, non-compliance may be high because most benefits accrue
in the future and are inherently uncertain, while substantial costs, especially
for newly covered groups, are incurred in the present. Therefore, improved tax
administration and a major public relations effort are needed to convince most
groups that they will indeed be better off covered and should comply.
A third risk stems from resistance from local authorities--currently
municipal and later on provincial--who may wish to perpetuate their control over
the pooled reserves. The more entrenched they become, the more difficult it may
be to overcome this institutional resistance and eventually move toward a
national system, when this is justified on efficiency grounds. Thus a system that
is meant to be temporary could take on a life of its own and become permanent,
as a result of institutional interests that develop during a policy of
gradualism. A carrot that can be used to overcome this resistance is the fact
that broader pools with newly covered enterprises will reduce the required
contribution rate in most cities with older plans and pensioners. This is a
political argument for moving quickly toward a national pool, while coverage
expands.
The biggest risk is the possibility that the Chinese government will be
unwilling to relinquish public control over the allocation of pension funds or
to pay an interest rate that correctly reflects the high marginal productivity
of  capital  in China  today.   Under  the current  circumstances,  with  local
government control, heavy required investment in central government bonds at
negative real interest rates, few alternative financial instruments and very
limited mobility of capital within the country, the accumulated pension funds are
declining rather than increasing in value. They are not being allocated to the
highest productivity uses nor will they provide a reasonable replacement rate for
workers upon retirement. If China implements a partially funded multi-pillar
pension system, it must go hand-in-hand with financial sector reform and
33



restructured investment procedures that emphasize the "right" mix of competition,
diversification and regulation, or the pension reform will ultimately fail.
34



Appendix: Notional defined contribution plans
In the past, defined contribution plans were fully funded, since money was
put into the accounts and invested, interest was earned, and pensions were paid
only to the extent that they were covered by these assets. More recently,
however, several countries, including Sweden, Italy, Latvia and some cities in
China, have begun experimenting with notional defined contribution accounts.
The basic idea behind a notional account is that a worker's account is set
up as a book-keeping device, to keep track of contributions plus imputed interest
at a rate determined by the government, but funds are never accumulated in these
accounts. Instead, the money is used to pay current benefits and the accounts are
notional or empty accounts. When the worker reaches retirement age, the notional
accumulation in his or her account is converted into an annuity (its size
depending on the expected duration of retirement and the interest rate) and paid
to the retiree out of contributions that younger workers are making at that time,
as they build up their own notional accounts.
A notional defined contribution plan has certain advantages over a defined
benefit plan. It produces a close transparent relationship between contributions
and benefits, thereby deterring evasion and other distortionary behavior. It
eliminates some undesirable redistributions within the same cohort, since all
individuals receive the same notional interest rate. It automatically adjusts
retirement age up or benefits down as expected lifetimes increase, thereby
preventing pension costs from rising as fast as they would otherwise.
However, so long as the accounts remain notional, the system is essentially
PAYG. It will not increase long term national saving. Like all PAYG systems, it
will produce sharp rises in required contribution rates and large inter-
generational transfers as populations age. And because the interest rate paid
into the accounts is largely notional rather than determined by actual returns,
it is highly subject to political manipulation. For example, it may be lower than
the market rate, implying that workers are not getting back the full market value
of their contributions, which are thereby being diverted to cross-subsidize other
government activities. Or it could be higher than the market rate, implying that
35



future generations may face a heavier tax burden than expected in the future to
pay these obligations.
In a partially funded, partially notional system, a reserve is accumulated
to partially back up these accounts. It is possible for the funded part of each
account to be managed in a decentralized way--for example, workers or unions and
employers could choose the investment manager, who is then given considerable
control over the investment strategy. However, because the reserves are only a
small part of each account, their management and investment strategy are more
likely to be centralized, leading to the capital misallocation and low yield
problems discussed in the text. Finally, since the accounts are largely notional
from the start, they may never become largely funded even if contributions
substantially exceed expenditures at some future point. Instead of regarding the
use of funds in the early years as a loan which must be repaid later on when
revenues exceed expenditures, governments may simply use any later surplus as
part of their general finance. For all these reasons, partially funded notional
accounts may quickly degenerate into empty notional accounts, which in turn are
very much like unfunded PAYG systems.
The multi-pillar system is less susceptible to these dangers because it is
more likely to be competitively managed with diversified portfolios and with
lending to the government at a market-determined rate, with an explicit
obligation to repay.
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Table 1. Population Aging in China
1995   2000   2030   2050   2100
Proportion of population over    9        10     22      26     30
age 60
Demographic dependency ratea       17     18      43     53     63
System dependency rateb            21     24     42      55     71
Reformed system dependency ratec 21       15     25      33     46
Average age of population          30     31      38     40     42
Expected duration of retirement  19       20      23     25     26V
with current retirement age
Expected duration retirement-if  19       19      19     19     19C
retirement age increases
% Workers who are urban-if no    26       26     25      25     24
urban in-migrationd
i Workers who are urban-with       26     28     39      46     49
urban in-migration'
% Workers who are urban+TVE        47     54     82      84     85
(rural industry)
Source: World Bank Population projections and simulations by
authors.
a    Population over age 60/ population aged 20-59
b    Pensioners/covered workers, based on simulations with
unchanged retirement age, rural/urban division and coverage
Pensioners/covered workers, based on simulations with
increased retirement age, rural/urban migration and expanded
coverage. See Table 2 for rate of increase in retirement
age, rate of urban in-migration and coverage expansion
assumed.
d    By "urban" is meant existing cities. As population and
industry grows in "rural" areas they too will become
"urbanized", but they are not considered "urban" in this
table.
e    These numbers apply to 2065, not 2100
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Table 2. Baseline and Alternative Assumptions
1995-     2011-     2051-
2010      2050       2100
Real wage growth-baselinea                   5.5%       3.0      3.0%
Slow growth                               1.0%       1.0%      1.0%
Real interest rate-baseline                  0.0%       4.0%      4.0%
Past reform                               3.0%       4.0%      4.0%
Slow reform and slow growth                 0        1.0        1.0
Noncompliance + exemption rate                25%        25%       25%
Benefit rate (average pension/ave. age)
baseline                                    80t       80%        80%
Reform                                     60%       60%        609
Replacement rate of final year wage
baseline                                   73%       73%        73t
Reform                                     55%       55%        55%
Retiremeint age - M                           60         60        60
- F                           55         55        55
Reform (at end of period) - M              60         65        65
- F            60         65        65
Rate of increase per year in            4 months      2          2
reform                                             months    months
Indexation to real wage-baseline              50%       50%        50%
Reform (price indexation)                   0         0          0
Coverage rate - urban                         72W        72%       72%
Increased urbanization-baseline                0          0         0
In-migration rate b                       1.5%       1.0%        0
TVE + private share of rural labor            28%        50%       70%
(at beginning of period)
TVE + rural private coverage                   0          0         0
Alternative-at beginning of periodc        30%       54%        80%
Increase per year in TVE labor share &    1.5%          1.5%        0
coverage rate (percentage points)
Ratio--rural to urban wage                    70%        70%       70%
In addition to this rate of economy-wide wage growth, which applies
to all cohorts, workers are assumed to receive a 1% per year wage
increase for experience during their first thirty years of
employment. This generally does not affect the average wage growth
in the economy or the ratio of average pension to average wage (the
benefit rate) but it does affect ratio of pension to final year's
wage for the average retiree (the replacement rate).
Only applies to population under age 35. Gives % increase in urban
share of total population in each group under 35. (eg. if the urban
share was 30% in 1995 it becomes 30.45% in 1996)
Covered TVE workers are eligible for pensions beginning with those
who retire in 2011.
38



Table 3. Break Even Contribution Rates for Reformed PAYG Defined Benefit System
(percentage of wage bill)
1995   2000   2010   2020   2030   2050   2100
(1)  Current system -- baselinea          20     22     21      27     37      49     60
(2)  Current system - slow growth         20     23     25      30     40      54    68
(3)  Reduced replacement ratio            20     20     17      21     28      36     45
(4)  Increased retirement age'            20     21     20      24     29      33    42
(5)  Price indexation                     20     19     17      23     32      42     50
(6)  Price indexation - slow growth    20        22     24      29     38      50    63
(7)  Rapid interest rate reform           20     22     21      27     37      49     60
(8)  Delegated interest rate reform    20        22     21      27     37      49     60
(9)  Combined reforms'                    20     17     13      15     19      21     27
(10) Combined reforms with coverage    20        12      7      12     16      20     26
expansion
a     Current system means 80% replacement rate; retirement age 55 for women, 60
for men; 50% real wage indexation.  See Table 2 for baseline and reform
assumptions.
b     Retirement age for women raised to 60 by 2010. Retirement age for men and
women raised to 65 by 2040.
Combined reforms mean 60% replacement rate, retirement age raised to 65 for
men and women by 2040, price indexation, rapid interest rate reform.
d     See Table 2 for increased rate of migration to urban areas and coverage
expansion in rural areas.
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Table 4. Uniform Contribution Rates for Partially Funded
Defined Benefit System
(percentage of wage bill)
1995-2100   1995-2050   2051-2100
(1)  Current system -- baselinea            41.1        32.1         54.7
(2)  Current system - slow growth           48.7        36.0         61.6
(3)  Reduced replacement ratio              31.3        24.9         41.0
(4)  Increased retirement ageb              30.5        26.0         37.3
(5)  Price indexation                       34.9        27.5         46.3
(6)  Price indexation - slow growth         45.8        34.3         57.5
(7)  Rapid interest rate reforms            40.5        31.6         54.7
(8)  Delegated interest rate reform         50.6        35.9         56.0
(9)  Combined reform                        19.8        17.2         23.8
(10) Combined reforms with coverage         18.3        14.6         23.1
*     Column 1 gives uniform contribution rate through time that will equate the
present value of revenues and expenditures from 1995-2100. Columns 2 and
3 give the uniform contribution rates for 1995-2050 and 2051-2100 if the
system is balanced separately for these two period. See Table 3 for other
definitions.
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Table 5. Replacement Rates Under Multi-Pillar System for
19 Years of Expected Retirement
Year of     No. years    No. years   Transitional         D C          Total
Retirement       work          work          +Basic       Pension"   Replacement
Old Systema   New Systema     Benefitb                     Rate
2000              37             5             60            3            63
2020              19            25             42            15           57
2030              10            35             33            22           55
2040              0             45             23            30           53
2050              0             45             23            32           55
2060-2100         0             45             23            32           55
a     Expected working period increases as retirement age increases, but
this is partially offset by schooling increase.
b     This gives replacement rate of final year's wage for average member of
retiring cohort. Formulas for transitional and basic benefits are
given in text. Pension from DC individual accounts is based on
baseline wage growth and interest rate assumptions in Table 2.
Retirement age is reformed option in Table 2.
Expected period of retirement is 19 throughout. Increased longevity
is offset by increased retirement age.
Price indexation of pension is assumed.
Contribution rate to DC pension is 8.5%, of which .3W goes toward
administrative expenses.
For contribution rates to transitional + basic benefit seet Table 6.
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Table 6. Annual Contribution Rate needed for Multi-Pillar System, Including
Transition Costs
1995   2000   2010   2020   2030   2050  2100
No ExDanded Coverage
(1) Total (incl. 8.5% D.C.)            28.5   25.5   20.5   19.5   19.5   17.5  19.5
(2) Transition cost                    20     15       8      5       3      1      0
(3) Basic Benefit                       0      2       4      6       8      8    11
Exianded Coverage
(4) Total (incl. D.C)                  28.5   20.5   15.5   15.5   16.5   16.5  19.5
(5) Transition cost                    20     10       4      3      2       0      0
(6) Basic Benefit                       0      2       3      4       6      8    11
This table assumes that the 8.5% DC contribution began in 1995.
42



Table 7. Uniform Contribution Rate needed for Multi-Pillar System,
With Borrowing to cover Transition Costs
1995-2100   1995-2050   2051-2100
No Expanded Coverage
(1) Total (incl. 8.5% D.C.)                  19.7         20.4          18.5
(2) Transition cost                            3.7         6.0           0
(3) Basic Benefit                              7.5         5.9          10.0
Expanded Coverage
(4) Total (incl. D.C)                        17.4         16.8          18.2
(5) Transition cost                            1.6         2.8           0
(6) Basic Benefit                              7.3         5.5           9.7
*See Table 6 for definition of uniform contribution rate for basic benefit
+ transition. Defined contribution (DC) rate = 8.5%.
43



Table 8. Annual Surplus and Total fund in Transition Account and Pillar Ia
1995   2000   2010   2020    2030    2050    2100
Without coverage expansion
Revenues minus Pension Payments
in transition account
as t of covered wage bill                (12)    (8)    (8)    (3)       (1)      (2)     (3)
Funds in transition acct+Pillar I         (6)   (30)   (36)    (38)    (43)    (33)       0
as % of current covered wage bill
as % of 1995 covered wage bill            (6)   (41)   (96)   (145)   (221)   (318)       0
With coverage expansion
Revenues minus Pension Payments
in transition account                    (13)    (6)    (2)      (1)      0       1
as t of covered wage bill
Debt of transition acct+ Pillar I         (8)   (19)   (7)        6       13      22       0
as % of current covered wage bill
as % of 1995 covered wage bill            (8)   (37)   (35)      59      194     634      0
a numbers in parentheses are deficits or debt.
44



Figurel. Trade-Off Between Retirement Age and Contribution Rate*
35
30
25
U)~~~~~~~~~~~~~~~~~~~~~~~~~~~~~2
4-
20
i  20
0
n
.0
c 1 5-
0
60        61         62         63         64         65         66         67         68         69         70
*See footnote 3 for assumptions                 Retirement Age
45



Figure 2. Trade-Off Between Retirement Age and Replacement Rate
(Holding Contribution Rate Constant)*
100
94
90
80
70
60
| 60<
E: 50-
4..
CL
40
30
20
30
20 -
60        61        62        63        64         65        66        67        68         69        70
*See footnote 3 for assumptions                   Retirement Age
46



Figure 3. Pension Relative to Average Wage under Price and 50% Real Wage Indexation
0.8I
0.7 -
0.6  - -
Z             + ,                                         so~~~~~~~~~~~~~~~~~~~% real wage indexation
Im 0.5
Ch
0.4                                                                                                             0.41
0
a-
L  0.3 
price indexaton
0.2                                                                                                            0.21
0.1
CM          V   L   CO  Cl  0)0 CDa            4  C        U.) CO  tr-  C   0)  0       N   co)  4w  U)
O q        X    X O q    X   .            C-  N   N  CN   N   N   N
Years after retirement
47



Figure 4. Relative Position of Young, Old and Very Old Under Price and 50% Wage Indexation
(Contribution Rate Constant)
0.8
0.7-
0.6 
0.5- 
.°                                               pure                           reaxalo wag indxaio
0)
0 0.5
0.2t~ ~~~~~pr n xa_o 0.36
0.
44~~~~~~~~~~~~~4
(U
0.4                                                                                                          .2
0.1~ ~ ~ ~ ~ ~ ~ ~ ~~ ~~~~~~~~~~~~~~~~~~~03
0~
o   '  (M  'q  U)  (0  1-  (0  0)  0             M-CI ~   *  Un  CD  f-  0,  0   0                L-(J(~      O
Years after retirement
48



Figure 5. Impact of Expanded Coverage on Contribution Rate,
and Comparison to Transition Costs*
0.3
0.25 -
0.2 1  \  \<           ~~~~Refoffmed Multi-Pillar
0.2
0.15                              Reformed Multi-Pillar, Expanded Coverage
0.1
0.05
RatedNeeded  to Finance Transition
O- I                                    I             X             X    - I
1995     2000      2010     2020      2030     2040      2050     2060      2070     2080      2090      2100
*Based on rows 1, 2, 4 in Table 6.
49



Figure 6. Comparison of Alternative Systems*
0.6
0.5
0.4
0.3
ulti-Pillar--no b                                        Reformed PAYG with Coverage Expansion
0.2                                               _
Uniform Rate for Partially Funded DB
Uniform Rate for Multi-Pillar
0.1
0 -
1995     2000      2010      2020     2030      2040      2050      2060     2070      2080      2090     2100
mBased on Tables 3, 4, 6 and 7
50
ESTELLE2.XLS



References
Friedman, Barry and Leonard Hausman. Social Protection and Economic Restructuring
in China. Manuscript.
World Bank 1994. Averting the Old Age Crisis: Policies to Protect the Old and
Promote Growth.  (Washington DC and New York: World Bank and Oxford University
Press).
1994 Statistical Yearbook of China. (Beijing: State Statistical Bureau).
51






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