What Is the Chinese Pension System and Why Are Its Problems Hard to Fix?

Within two decades, China’s retirement-age population is projected to surpass the entire population of the United States. By 2040, an estimated 402 million people, or 28 percent of China’s population, will be over sixty years old—the current legal retirement age for most men in the country. By that time, the U.S. population is expected to reach 379 million. This trend means the end of China’s comparative advantage in cheap and skilled labor and the daunting financial challenge of caring for its rapidly aging population.

Chinese President Xi Jinping is determined to achieve technological self-reliance, hoping that innovation will improve China’s labor productivity and offset any potential future labor shortage. But even if Xi’s initiatives are successful, they will do little to address the financial burden posed by China’s underfunded social security and pension system. A 2019 report by the Chinese Academy of Social Sciences (CASS) warned that as the worker-to-retiree ratio declines, the National Social Security Fund (NSSF), established in 2000 to finance China’s future pension obligations, would likely be depleted by 2035.

China’s overarching social security and pension system, the Old-age Insurance System (中国养老保险制度), covers pensions, illness coverage, work-related injury benefits, and maternity support. Initially serving urban workers nationwide, it originated in 1951 with the issuance of the “Regulations on Labor Insurance” by the State Council. In 1952, the government introduced a separate pension system for civil and military servants. Over time, the system has undergone two distinct phases: the first phase was the national insurance model (1951-1986) during the planned economy era, when enterprises were the “iron rice bowl” responsible for funding the system with government guarantees and no need for individual contribution. The second phase combined social pooling and individual accounts model (1986-present) to adapt to the transition towards a market economy. During this time, the government has been developing a three-pillar system, as described by the Ministry of Human Resources and Social Security. The first pillar, which is also the main pillar of China’s pension system, is the basic pension system established in the 1990s, in which contribution rates and payout benefits are determined primarily by the beneficiary’s employment history and household registration (hukou) location, either urban or rural. To supplement the first pillar, the government introduced enterprise annuities in 2004 as the second pillar of the system, and in 2022 it launched individual retirement accounts (IRAs) as the third pillar.

By the end of 2022, China’s Old-age Insurance System has achieved nearly universal coverage, with about 1.05 billion people included, leaving about 350 million people uncovered. This group includes minors under sixteen, employees of firms unlawfully neglecting social security contributions, those who consider it unworthy or unaffordable, and affluent individuals who neither need nor value the minimal benefits. Urban salaried workers and individual business owners are covered under the Old-age Insurance for Employees plan, which covered about 503 million active workers and retirees at the end of 2022. Most of the rest of the population over the age of sixteen but ineligible for the above plan because they have a rural hukou or are unsalaried urban residents have the option to enroll in the Old-age Insurance for Urban and Rural Residents plan, which covered about 549 million people at the end of 2022.

The benefits of China’s Old-age Insurance System consist of individual accounts and a basic pension. The individual accounts portion is funded by a mandatory defined contribution plan, and the benefits are determined by individual pay-in. The basic pension operates on a pay-as-you-go basis, implicitly a defined benefit plan that guarantees a fixed retirement income expressed as a percentage of pre-retirement salaries (or replacement ratio). Retired urban salaried employees currently receive an average monthly basic pension of 3,326 yuan (about $461) per person, primarily financed by the statutory pension contribution paid by employers at a rate linked to the total wages paid to employees. Retirees under the urban and rural resident plan receive much less generous benefits, with an average monthly basic pension of merely 179 yuan (less than $25) per person that is financed by tax revenues and government subsidies.

Covering this many people is an impressive achievement—but the system faces two formidable challenges. The first challenge lies in the relatively high level of China’s statutory employer pension contribution rates compared to other countries at a similar level of economic development. The second is the plan’s fragmented administration by provincial governments.

China’s statutory employer pension contribution rate remains relatively high, even after the central government lowered the rate ceiling six times between 2015 and 2019. The last rate cut in 2019 lowered the maximum rate from 20 to 16 percent, still higher than about one-third of the rich OECD countries and significantly above the rates in the United States (10.6%) and South Korea (9.0%).

Beijing’s decision to lower the ceiling on the employer contribution rate aimed to reduce business costs, but it has also exacerbated the problem of declining pension fund revenues. In 2020, the temporary relief from pension contributions granted to employers decreased total revenue for the urban worker’s pension plan by 1.5 trillion yuan ($210 billion) or 28 percent. Combined revenues for China’s pension plans declined 13.3 percent, while expenditures increased by 5.5 percent, causing the pension system to record a first-ever annual deficit in 2020.

For the first time since its establishment, the NSSF had to disburse 50 billion yuan ($6.96 billion) in subsidies to help plug the funding gap in various provinces’ urban workers’ pension plans, according to a government budget report. As Chinese society ages, the defined-benefit portion of pension plans will come under growing pressure. At the end of 2019, the pooled surplus from the various provinces’ urban workers’ plans was 5.46 trillion yuan ($790 billion), enough to sustain only 13.3 months of benefit payments. The diminished payment capacity of these plans will intensify the strain on local government budgets and increase the likelihood of additional withdrawals from the NSSF to plug pension funding gaps.

Not all provinces can afford continuously lowering employer contribution rates. In richer provinces like Guangdong and Zhejiang, local social security funds receive more contributions than they disburse, enabling local authorities to afford lower contribution rates. By doing so, they effectively reduce social security costs for businesses, attract foreign investment, and create more high-paying jobs. This in turn helps grow the economy, attracts a younger labor force, and increases the revenue of social security funds.

The exact opposite happens in the rust belt, such as Heilongjiang, or the western inland provinces like Ningxia. These worse-off areas face a stark reality where their local governments struggle to fund pensions, forcing them to controversially issue debt to fund pension payments, as revealed in a 2015 report by the National People’s Congress. When implementing COVID-19 relief measures, the Ministry of Finance specifically prohibited local governments from using the proceeds from local government special purpose bonds to fund pension payouts.

Any change to the status quo means deciding who will bear the brunt of the changes, while maintaining the status quo risks forcing pension default in regions where provincial governments are already struggling financially. This conundrum is a trilemma for policymakers. At most they can manage two of three objectives—firm profitability, employment stability, and pension sustainability. Since 2015, the government has chosen to lower statutory employer contribution rates to help firms maintain profitability and prevent exacerbating unemployment. As a result, the plans themselves have inevitably become less sustainable.    

In theory, lowering employers’ contribution rates directly benefits firms by reducing their social security costs and enhancing profitability, which promotes job creation. Unfortunately, this has not been the case in practice. The Chinese pension system currently faces additional stress as the Chinese economy has struggled to recover from the pandemic, and the soft labor market has led to reduced pension contributions and higher benefit payouts.

High-paying jobs with career advancement potential are diminishing as multinationals execute supply chain diversification plans and shift investment out of China amid waning confidence and growing political, regulatory, and geopolitical uncertainties during Xi’s third term. Beijing has also announced civil servant job cuts to streamline bureaucracy and tighten expenses. Meanwhile, the Gen Z Chinese workers are either unwilling to take low-paying jobs for which they are overqualified or are quitting high-stress corporate jobs to settle for lower-paying but relaxed light labor jobs. A combination of these factors has led to record-high youth unemployment rates in China, resulting in greater dependency on the pension system with fewer salary earners and reduced pension contributions.

The numbers show how challenging this situation is. The 2019 statutory rate cut reduced employers’ pension burden by nearly 300 billion yuan ($43 billion). The 2020 temporary contribution reduction and exemption saved firms another 1.5 trillion yuan ($217 billion). However, easing the pension burden on companies has failed to spur job growth. Youth unemployment has doubled from the pre-pandemic level of 10 percent in 2018 to more than 20 percent in April 2023, far higher than the average of 10.5 percent in OECD countries.

The cost-savings to employers did not stop multinationals from scaling back their investment in China or just leaving China altogether. Amid rising U.S.-China tensions in 2019 more than fifty multinationals moved production out of China, including notable foreign firms like Apple, Nintendo, and Dell. Even Chinese firms like TCL and Sailun Tire have shifted some production overseas.

As long as the labor market fails to improve, pension revenues will struggle to grow enough to keep China’s social security programs fully funded, increasing the pressure on the government to fill the gap. A record 11.6 million graduates will hit the job market this year. The Party and the Communist Youth League have plans to mobilize China’s youth to participate in the rural rejuvenation strategy, harking back to the days of assigned jobs for graduates, in the hope of reducing unemployment and promoting rural development. This approach removes a portion of the young workforce from urban salaried job opportunities, decreasing contributors to the urban basic pension pool. It also fails to incentivize displaced young workers to voluntarily enroll in the rural pension system that offers limited benefits.

As a result of these problems, Beijing has decisively moved towards central coordination and establishing a national pension system, rather than one run through fragmented provincial governments. In 2018, the Chinese government launched a central adjustment fund for the urban enterprise employees’ pension fund. This central adjustment fund draws a set percentage from each province’s urban enterprise employees’ pension revenues in accordance with average local wages, and the number of corporate and self-employed workers. The pooled funds are then redistributed using a formula that accounts for the number of retirees in each province.

Initially, the fund drew 3 percent of base revenues from each province, but Beijing has steadily raised the central adjustment ratio by 0.5 percentage points annually from 2019 to 2021, reaching 4.5 percent in 2021. In February 2022, the government introduced a national balancing mechanism for the urban enterprise employees’ pension fund, allowing deficits in certain provinces to be compensated by nationwide surpluses, representing a serious step toward centralizing the whole system. The government has set the completion of a national basic employee pension system as a goal by 2035.

Beijing has also been replenishing the social security fund by transferring state-owned capital to the fund and increasing subsidies. By the end of 2021, the central government had transferred a total of 1.68 trillion yuan ($260 billion) of state-owned capital from ninety-three central enterprises and central financial institutions to strengthen the funded status of the social security fund. In 2019, the central government allocated 528.5 billion yuan ($76 billion) to subsidize urban enterprise employees’ pensions, marking a 9.4 percent year-on-year increase. In 2020, the subsidy again increased to 580 billion yuan ($84 billion). These subsidies far exceeded any previous year, with the total during just these two years equaling about one-third of the total over the prior twenty years.

Beijing has introduced enterprise annuities and IRAs as two additional pillars to supplement the distressed basic pension system. The newly launched tax-deferred IRAs have developed much faster than enterprise annuities. As with retirement accounts in other countries, participants can choose to invest funds in their IRAs in certain financial products to earn a higher return but individually bear the investment risk. Within three months since its initial rollout, the plan enrolled nearly 30 million people, about one-third of whom made initial contributions totaling about 20 billion yuan ($2.9 billion). Participation in the plan is projected to expand rapidly with its total assets reaching 163 billion yuan ($23 billion) by 2025 and a further five-fold increase to 884.9 billion yuan ($124 billion) by 2030.

In contrast to the rapid uptake of private plans, enterprise annuities have made little progress. By 2022, out of the fifty-three million eligible participant firms in China, only 128 thousand, less than 0.25 percent, had enrolled in the plan. Furthermore, only 30.1 million of the entire 733.51 million employees nationwide (about 4 percent) were enrolled in the enterprise annuities system. Most participants are employees of state-owned enterprises or large private firms, while small-and medium-sized enterprises have a low participation rate. Two primary factors have hindered the progress of the enterprise annuities. First, the high statutory pension contribution rate has overshadowed enterprise annuities. Second, SMEs often lack the resource and capacity to deal with the complex administrative procedures involved in establishing their own enterprise annuities, and their employees often lack sufficient income to make contributions.

The Chinese government’s decision to introduce market-based retirement plans is the right move. Such plans can supplement the basic pension scheme and transform private savings into publicly investable capital, which can then fund various projects that seek patient capital. However, although the Chinese government has called for a market-based pension investment management approach, it has strongly encouraged pension fund managers and the entire insurance industry to invest in state-prioritized projects and sectors, such as infrastructure and strategic industries, effectively limiting their options for political ends. For example, in 2010, the State Council encouraged enterprise annuities and pension fund managers to support strategic emerging and frontier industries by making venture and equity investments.

An even bigger challenge for China lies in the lack of support for rapidly aging migrant workers. Over the past 40 years, a growing number of migrant workers provided cheap labor fueling China’s decades-long construction spree and manufacturing boom in coastal regions and inland cities. However, in the most recent decade, migrant workers have been aging faster than the national average. Between 2009 and 2022, the average age of migrant workers increased by nearly eight years (from 34 to 42.3), with close to one in three of them (29.2 percent) above the age of 50. In comparison, the national average age of Chinese workers increased by less than three years (from 36.79 to 39). Despite China’s first generation of migrant workers are exceeding the legal retirement age, many of them continue working intense labor jobs because their rural hukou denies them better retirement benefits available to urban salaried workers, leaving them with inadequate social security payments averaging between 100 yuan (less than $14) and 200 yuan (about $28) per month.

This trend is even worse in labor-intensive sectors like construction and interior decoration, which directly support the property sector that contributes to about 30 percent of China’s GDP. Back in 2017, nearly 43 percent of workers in these sectors were above fifty, while only 15 percent of them were below thirty. This contrast indicates a lack of labor replacement within the property sector that has fueled China’s rapid growth. While automation and technological advancements have reduced labor demand, the lack of adequate pension support in rural areas has significantly delayed migrant workers from retiring and prevented young laborers from joining the trade.

Chinese policymakers are well aware of the country’s demographic challenge. However, they may not have been fully prepared for the urgency and severity of the challenge. In 2019, when CASS published its demographic report, China had not yet experienced prolonged pandemic lockdowns, foreign firms had not accelerated their plans to move out of China, and local governments had not exhausted their resources on massive COVID-19 testing programs.

 Annual budget reports from local governments revealed that in 2022 alone Chinese provinces spent at least $352 billion yuan ($51.6 billion) on COVID-19 containment. As the Chinese economy struggles to regain its growth momentum, mishandling the funding and distribution of pension benefits could become another threat to social stability, alongside high youth unemployment and occasional runs on small banks. As a reminder, earlier this year in February, hundreds of thousands of Chinese pensioners protested against local governments for cutting healthcare benefits, expressing their dissatisfaction and frustration through chants like “down with the reactionary government” and singing “The Internationale.”

President Xi Jinping and the Party face a critical decision as they weigh the competing priorities of securing funding for the welfare of Chinese elderly citizens and allocating resources to pursue technology self-reliance. The reality of a struggling economy dictates that they do not have sufficient resources to prioritize both.

The original version of this piece has been referenced in other reports, including this Bloomberg Originals documentary and this Bloomberg article.