Financial sustainability of the pension system in China: Impact of fragmented administration and population ageing

Abstract

With a rapidly ageing population and a highly fragmented pension system divided into over 2,000 pools managed separately by local governments, the financial sustainability of the Chinese pension system is facing serious challenges. This study aims to investigate the impact of fragmentation and population ageing on pension sustainability in China. By examining the history of pension reform and policy evolution in the context of overall development of China, the study conducts an analysis on the consequences of fragmentation based on both evidence obtained from fieldwork and secondary data including policy documents and official statistics. The distortion in incentives for local governments is documented in case studies covering both the coastal and inland regions. These case studies demonstrate how pension sustainability is compromised by various adverse effects produced by fragmentation, such as the moral hazard caused by the disarticulated intergovernmental fiscal responsibility. An overlapping generations (OLG) model is updated with the latest demographic data and used to perform a prospective assessment of the impact of population ageing on pension sustainability in China and to help determine whether adjustment in retirement age can ensure long-term financial sustainability under various demographic scenarios in the rest of the century.

Overall, the findings of this research reveal that, compared to the population ageing, the issues stemming from the fragmentation pose a more insidious threat to pension sustainability in China. The retirement age reform alone can only provide a necessary but not sufficient condition for ensuring the system’s long-run financial sustainability, abstracting from the significant negative impact of the fragmentation. Problems of moral hazard such as noncompliance by local governments and challenges of adverse selection resulting from the administrative loopholes in the highly decentralised system, if left unchecked, are classic reasons why insurance policies including pension schemes go bankrupt. Therefore, if China wants to ensure the long-term sustainability of the pension system, it is imperative to take its reform to the next level by defragmenting the system. The possibility of the fertility cliff and the danger of the de facto bankruptcy brought by the population ageing further highlight the urgency to address the fragmentation as the underlying cause of the many defects of the system that are damaging pension sustainability.