A recent guideline released by China's State Council has given China’s pension funds the green light to invest in the stock market. Pension funds were previously deposited in banks or invested in treasury bonds. According to an estimate from the Chinese Academy of Social Sciences, inflation over the past 20 years has taken a toll on China’s pension funds, resulting in depreciation by nearly 15.7 billion U.S. dollars. Under the new guideline, pension funds will now be allowed to invest in shares and other market instruments, including derivatives.
Although the Chinese government has maintained that the guideline is intended to ward off inflation pressure and help pension funds yield more, some view it as a desperate move to save the plunging stock market. “The move is the latest attempt by the Chinese government to arrest the slide in the country's stock market,” reported the BBC on August 23. It seems that the timing for this new regulation has created confusion about its true purpose.
As China’s population ages, it is of great public concern to determine whether this move will help to alleviate the mounting pressure on China’s social security system or just risk people’s money to save the drowning market. Peking University HSBC Business School Assistant Professor Insook Lee addressed the guideline’s underlying purposes, market risks and impacts on fiscal policies. Lee earned her PhD in economics at the University of California, Berkeley, and her research field is public finance with a focus on public pension systems, taxation, and public policy.
Q： Do you think it is a wise move that China has allowed pension funds to be invested in the stock market when the country is suffering an economic slowdown and a bear market?
A: Achievement of reducing risk and raising investment return at the same time is aspired but far from easy. The stock market is usually risky (highly volatile) although it yields high expected return. So, it is not a good idea to invest all public pension funds in the stock market. For example of OECD countries（Organization for Economic Co-operation and Development）, they diversify the investment of their public pension funds across various devices such as equity, bills and bonds, cash and deposit. But none of them put the largest part in the stock market. On the other hand, if investment in the stock mark is intended for raising expected return so that the Chinese government can enlarge the future public pension revenue, then hedging activity to reduce the entailed risk from the stock market investment had better be paired in tandem.
Regarding the timing of investing in the stock market, public pension funds investment is intrinsically long term. Therefore, business cycle fluctuation such as bear market or bull market is short term and thus not an essential issue. Rather, what matters more is to penetrate the true underlying value of the stock that the government would purchase with the public pension funds.
Q: Given the potential risks of pension fund investment, what measures should the government take to ensure the safety of citizens’ pension funds? Could we draw any lesson from pension fund policies in other countries?
A: Controlling long term risk is always important for pension fund investment. Moreover, as a provider of social safety net, the government is not a profit seeker. So, pursuing high returns in the short term might not be the first priority of the public pension fund investors. Having been clearly aware of such stance of investment, the government should constantly check upon the moral hazard issue. As you know, those who decide where and how to invest public pension funds are not fully bearing the risk related to the investment; rather, the risk eventually falls upon ordinary Chinese people who have sincerely paid pension contributions with their own hard- earned money.
Q: Compared to 401(k) in the U.S., China’s pension fund is only allowed to be invested by an official national agency. In that case, citizens have to pay for losses that the agency causes but might not fully benefit from the investment gains. How to solve this paradox? Is it better that China allows individuals to participate in their own pension fund investment in the future?
A: As 401(k) is not operated by the government but by private financial brokerage companies, it is not a public pension program.The investments of the US public pension funds, which is called Old-Age and Survivors Insurance (OASI) trust fund, are also made by a national agency, instead of citizens themselves. Thus, I do not think it is a paradox. Moreover, if individuals decide where to invest their own pension funds, then it is no longer a pay-as-you-go system and imposes greater risks on individuals, which is self-defeating and against the original motive of the government for providing social security.
Q: If it is a general trend that governments worldwide will launch policies to allow pension fund investment so as to stabilize value, then what should be taken into account before formulating such policies?
A: As you know, the Chinese public pension system is a hybrid system, mixing pay-as-you-go finance and funded investment in the private financial market. And the part underpinned by the pay-as-you-go basis finance will actually enable the Chinese government to valorize pension payments to price level changes, protecting retirees from inflation shocks. As a matter of fact, almost all the pay-as-you-go public pension systems around the world have long provided their pensioners inflation adjustment, without a special investment strategy of their public pension funds. To put another way, ‘to stabilize its value against the inflation’ is not directly hinging upon investment strategy of public pension funds. As long as the Chinese government keeps the pay-as-you-go part and its economic growth momentum, there seem no additional measures or policies that need to be taken for that matter.
Q: As China’s population ages, will this policy alleviate pressure on the government to ensure financial support for retired citizens? What kind of impact will this policy impose on the government fiscal plan?
A: I think that one of the reasons why the Chinese government decides to allow public pension funds to be invested in the stock market is for the sake of increasing future public pension revenue. As I mentioned above, as the stock market is more volatile, it is not certain whether this policy can actually achieve to alleviate fiscal pressure. In other words, further risk management would be added in the fiscal plan for the government.
As the interview suggests, the timing of this guideline is not an issue to worry about since public pension fund investment is intrinsically long term regardless of short-term business cycle fluctuations such as a bear market or a bull market. Therefore, it seems that the move is more of a policy breakthrough to diversify investment channels than a practical boost to shares in the short term. In the long run, if it works well, higher investment returns under this guideline might help to narrow the huge pension gap in China’s aging society. According to an International Monetary Fund estimate, the gap accounts for 76% of last year’s GDP. Therefore, the guideline could be regarded as the latest attempt by the government to address the problems of an aging population, including a diminishing work force growth and weak domestic consumption.
However, considering stock market volatility, the Chinese government should put emphasis on risk management and check on the moral hazard issue, according to Lee. The Ministry of Human Resources and Social Security (MHRSS) said that a reserve fund will be set up to offset losses and investment in stocks, and equities should account for no more than 30 percent of total net assets. It is believed that with risk control measures, the government could better shape the pension fund investment agency into a reliable long-term institutional investor, facilitating the sustainable development of financial market.
Further, to obtain high returns and avoid investment disasters, people need know how to diversify investment and choose portfolios. However, many individuals do not have such knowledge and are often driven by short-term investment gains, putting the investment of public pension funds at risk. That explains why public pension funds in many countries are often invested by national agencies instead of individuals. In the future, whether individuals will have more say in pension fund investment and fully benefit from the investment gains remains to be discussed.
By Annie Jin
Edited by Priscilla Young
