Abstract: The biggest challenge for China to develop the third pillar pension lies in how to improve the appeal of pension products and channel huge household savings into the third pillar pension system in the absence of capital gains tax. China should strengthen top-level design, and employ both the EET and TEE models to provide tax incentives.
Ⅰ. INCOMPLETE SYSTEM DESIGN IS THE CRUX OF THE THIRD PILLAR PENSION.
1. Participation of the wealth management subsidiaries of commercial banks in China’s personal pension market
The advantage of wealth management subsidiaries of commercial banks is their short-term wealth management products. The market for these products in China is relatively mature with a large coverage and a great impact on the financial management methods employed by individual investors.
As China push forwards with the development of the third pillar pension system, will there be a market for short-term wealth management products? Certainly there is, and not only in the forms of Life-Cycle Funds, or Target Date Funds.
In my opinion, the cultural foundation of the market for banks’ wealth management products in China is perfectly embodied in mahjong—Chinese people enjoy the game so much precisely because of the hands-on satisfaction from drawing and discarding tiles. A life-cycle fund, which deducts a certain amount from wages every month and earns a certain amount after several decades, doesn’t fully conform to the habit of many Chinese people, but it works for employees who work regular jobs and certain occupational groups. In China's currently immature investment market, transactions of short-term wealth management products are very active.
Therefore, as China's personal pension system develops, there will be a market for short-term wealth management products at least for a period of time. Banks’ wealth management subsidiaries shouldn’t ignore this advantage and the market. Policymakers also need to consider this issue.
Some believe that the wide customer base of commercial banks gives them an intrinsic advantage in terms of developing pension finance. For example, Postal Savings Bank of China has nearly 40,000 business outlets, covering 99% of counties and cities in China in service of 600 million individual customers. Major state-owned banks all have great user penetration rates, but customer coverage has never been the bottleneck for the development of China's pension market.
The difficulty in establishing the second and third pillar pensions in China is not the lack of sales channels, but the incomplete system design that cannot meet the various needs for products or further activate the potential market. The result is the lack of consumer interest in pension products and the long-term loss that financial institutions suffer which defers them from introducing more such products.
Neither the tax-deductible health insurance launched 7 years ago nor the pilot tax-deferred commercial pension insurance launched 4 years ago were as successful as expected. These two cases show that the key to building the third pillar pension lies in system design and product design, rather than the sales channel.
2. Tax incentives for pension products
Countries with a good third pillar pension typically adopt both EET and TEE in their design. Simply emphasizing the EET model will cause problems in practice.
Even United States and Canada where capital gains tax is common have combined EET and TEE to achieve the current high coverage of third-pillar pension. Here, the " coverage" refers to the ratio of the number of people joining the third pillar pension to the number of people aged 15-64. The rate is 19.8% in the US, 67% in Canada, and 98% in New Zealand.
China has no capital gains tax, and due to the high threshold for personal income tax, the number of taxpayers is small. In the EET system, the contributions are exempt from corporate income tax and personal income tax, the accumulation is exempt from personal income tax, and only the benefits withdrawn will be subject to personal income tax. The problem is that the people who pay personal income tax are generally well-to-do, and the annual contribution of 12,000 yuan of personal pension holds little appeal to this group, so the upper limit of the contribution for this group can be increased to, for example, 24,000 or 36,000 yuan per year. Most middle- and low-income groups care more about pensions, but they are probably not taxpayers, and the deferral of personal income tax makes no difference to them. Generally speaking, the population group where EET is applicable overlaps with the group covered by enterprise annuity, which makes EET’s scope of coverage rather limited.
While under the TEE system, accumulation and benefit withdrawl are exempt from personal income tax and only contributions are subject to corporate and personal income taxes. This means that a sizable part of the population in China won't be required to pay taxes, and their demand for private pension will be huge. From this point of view, China must employ both EET and TEE to serve two distinct groups.
Some scholars advocate for the EEE model. I understand that they want to implement greater preferential measures and maximize coverage, but in my opinion, the EEE model is not feasible for two reasons:
First, only a very small number of countries adopt EEE. Mexico and Slovakia are special cases where EEE has a rather low coverage, insufficient to serve as samples to learn from.
Second, income from investments should be exempt from tax when people draw their pensions and pay the personal income tax. This arrangement is consistent with the absence of capital gains tax in China. As long as participants of the third pillar pension plan do not suffer any losses, the system will continue to provide incentives as tax remains the same no matter people contribute to the pension or not. People still have to pay the tax for the principal. Participating in the private pension plans doesn’t make any big changes to this. The only difference or advantage is deferred payment of personal income tax.
From this perspective, a Chinese model of tax incentive for private pensions that meets the country’s needs would not be EEE, but EEpT, where "p" means "partial".
In terms of providing incentives, the effects of EEE and TEE on expanding the pension coverage are roughly the same, because under the condition that the two preferential tax models of EET and TEE are implemented at the same time, taxpayers and non-taxpayers will each take what they need, and the absence of capital gains tax is also resolved. This has been proved by cases abroad. However, the shortcomings of EEE are more obvious than TEE. The key lies in the understanding of the first letters E and T. EEE has shortfalls and no benefit when coverage expands. With the expansion of EEE coverage, the government will lose more personal income tax. If China adopts this model, it will become one of the “very few” countries and suffer a double whammy as the EEE approach contributes little to expanding pension coverage, but greatly reduces tax revenue for the government.
In contrast, TEE offers only benefits and does no harm to pension coverage and tax revenue. That is to say, there will be neither tax revenue loss nor reduced coverage because EET and TEE target two different groups, and there is no conflict between them. TEE is aimed at non-tax-paying groups. The best international practice is to implement the two models, TEE and EET, at the same time, so that different groups can pick what they need. This should be the direction for further study and reform.
In summary, China should adopt two preferential tax models for the third pillar private pension, namely the EEpT model and the TEE model. It should be noted that the essence of the EEE model proposed by some should be EEpT.
3. Exclusive pension insurance products
On May 1, 2018, China launched a pilot program for tax-deferred commercial pension products. On this basis, China Banking and Insurance Regulatory Commission rolled out the “exclusive commercial pension” pilot program in Zhejiang and Chongqing on June 1, 2021, with the participation of six life insurance companies, a significant step towards enriching China’s pension products and addressing people’s various demands.
However, the pilot scheme was not a success. In contrast, under the recently launched pilot program of exclusive commercial pension, without the support of tax incentives, 160,000 or so policies was sold with a premium income of nearly 1.6 billion yuan, far outperforming the former in four years of its implementation. Many of the buyers of exclusive commercial pension products are employees in newly emerged sectors. Good performance of the pilot product has far-reaching significance. In February this year, the exclusive pension pilot was extended to the whole country with the participation of pension insurance companies.
An international practice of the third pillar pension statistics is to count the only products supported by tax incentives, while the fully market-based commercial insurance products that do not enjoy tax incentives are often not included in the statistics. Therefore, statistics only show the coverage rate and premium income of the pension schemes with tax incentives. Commercial pension can be broadly or narrowly defined under the framework of the third pillar pension plan. The exclusive commercial pension is a broad concept, while private pension with preferential tax treatment is a narrow concept.
All in all, the efforts made by the China Banking and Insurance Regulatory Commission on promoting exclusive commercial pension isince last year are worthy of recognition. Like the personal pension target fund launched by the China Securities Regulatory Commission in February 2018, it has achieved good results without tax policy support. Judging from the attributes of financial products and the practice of developed countries, compared with products such as public funds, pension products face considerable challenges in the competition.
Therefore, research should be done on how to make the exclusive pension products more appealing to private pension account holders.
This means that in the long run, exclusive pension products will have to meet the needs for "sense of gain", product diversity, and sustainability. As private pension account holders tend to vote with their feet, the third pillar scheme must be appealing. However, compared with public funds, insurance premium income is on-balance sheet assets of insurance companies who bear the risk of market fluctuations, and adopt a commission system which is often nontransparent. As for public funds, the products are off-balance sheet assets, the account holder bears the market risks, and a management fee is charged, which is relatively transparent.
Judging from the results of market research, the key to product attractiveness lies in the overall rate of return, or "sense of gain". If the settlement yield rate of "guaranteed + floating" is lower than 4%, this won’t be very appealing compared with other insurance products in the market, and won’t produce a sense of gain. If the insurance company increases the settlement yield rate by means of offering subsidy to 5%, 6% or even 7%, they will end up not only struggling with paying the commission, but also putting sustainability at risk. In fact, this is an "old problem", that is, how to strike a balance between product attractiveness (high yields) and the willingness of insurance companies to offer these products. This problem also existed in the pilot scheme for tax-deferred commercial insurance in 2018. At that time, it was difficult to encourage insurance companies to maintain enthusiasm for participation. Therefore, it is possible to increase product attractiveness with high yields in the short term, but the long-term sustainability of products must be considered in product design. Otherwise, even if a product becomes a qualified third-pillar pension product, it will be voted out by investors. Therefore, attracting investors by offering high settlement yields and subsidizing commissions must be changed.
In addition, it is necessary to increase the variety of products included in the third pillar pension scheme. To make the exclusive pension products more appealing and competitive, more types of products should be introduced such as participating insurance, investment-linked insurance, universal life insurance, annuity insurance, and even some health insurances, such as critical illness insurance and accident insurance,, because when people grow old, disease expenditures will rise. It is also necessary to develop annuity insurance for life-long payment, which also has market prospects. In short, the insurance industry should play to its strengths.
In fact, in order to cater to the demand for third pillar pensions, the insurance sector must shift its role from “salesperson” to “investment advisor”. Providing investment advisory services is also an advantage of insurance companies, which is not enjoyed by public funds. For a long time, the insurance sector has focused on "selling products", which gave rise to the "agent-commission system" and spurred the emergence of intermediaries and millions of salespeople. However, the initial cost of exclusive pension insurance is much lower than the that of traditional insurance products. Traditional sales methods, channels and concepts are not suitable for exclusive pension products, nor are the channels of banks. Therefore, not only the insurance industry is facing transformation, the exclusive pension scheme also needs major changes.
II. EFFECTIVELY STRENGTHEN TOP-LEVEL DESIGN AND MOBILIZE ALL POLICY RESOURCES FOR IMPLEMENTATION
4. When it comes to top-level design of third pillar pension, China still has to cross the river by feeling the stones.
When enterprise annuity was first introduced in China in 2004, there were many predictions about its development. Some predicted that it would reach 10 or 20 trillion yuan by the end of the last century. However, today the scale of enterprise annuity remains below three trillion yuan. For another example, it has been 15 years since the tax-deferred commercial pension was first put forward, and over 4 years since the pilot program was launched in 2018. At present, 40,000 people have participated in the scheme, resulting in a premium income of around 500 million yuan. In 2014, China launched a pilot program for reverse mortgage-based pension insurance, but so far there are only around 120 orders for the product, and only one or two insurance companies are involved in the program. The commercial health insurance with preferential tax treatment launched in 2015 has attracted more than 70,000 participants so far, and the premium income is merely two billion yuan, a too small number.
There is also the pension target fund launched in 2018. In terms of scale, it currently exceeds 100 billion yuan, and there are nearly 200 funds. However, it also belongs to the third-pillar pension scheme in a broad sense. Because there is no preferential tax policy and the retirement date cannot be determined, only 15% of the pension target funds are target-date funds, and the remaining 85% are target-risk funds. From this point of view, in the absence of preferential tax policy, pension target funds are thematic funds in essence. There is an urgent need for preferential tax policies, or to include the funds in the third pillar pension products.
The purpose of reviewing the market performance of various third pillar pension products in both broad and narrow senses is to better implement the Opinions of the General Office of the State Council on Promoting the Development of Individual Pensions (hereinafter referred to as the Opinions) released in April, and strengthen the top-level design of the scheme.
In general, despite the high expectations given by the media, we should have a sober understanding of current market conditions and reality, objectively look at the gap between people’s wishes and actual institutional design, and improve the top-level design with trial and error. In addition, it is necessary to tailor common practice to local situations, which requires a lot of meticulous and hard work. For example, the Employee Retirement Income Security Act (ERISA) in the United States has undergone several rounds of laborious revisions since it was promulgated in 1974.
In fact, the central government has recognized the difficulties facing the development of the third pillar pension. For example, the Opinions has kept the contribution cap of 12,000 yuan/year first proposed for the 2018 pilot scheme of tax-deferred commercial insurance. Why can't it be raised? Raising the contribution cap may cause misunderstanding among certain groups, who may think that people contributing at the maximum amount are privileged and rich. If not many people participate in the private pension scheme, an increase in the contribution cap will make it the target of criticism.
Decisions made by different government departments based on sectional interests may be well justified, but once they are integrated into institutional design, problems would manifest. For example, tax incentive for the private pension scheme is actually insufficient at the moment, but in the context of common prosperity, the relevant departments need to take into account public mood. If the number of participants in the scheme is small, boosting tax incentives may be criticized for creating a "rich club". From this perspective, to optimize the private pension system, China must strengthen the top-level design. For example, policymakers should work out an optimal combination between the number of participants and the level of tax incentives.
First of all, they need to set clear goals and select a model. There are two models of private pension systems: the alternative model and the supplementary model. The alternative model features a wide coverage on par with the first pillar, which can form a dumbbell-shaped pension structure, with the middle layer being enterprise annuity. This is because the participants of the enterprise annuity must be employees and there must be employers. In some countries, individual pensions can be set up at birth and opted out when the beneficiary reaches the age of 18. Therefore, the individual pension coverage under this model is greater than that of the second pillar or even the first pillar. During the process of top-level design, China must first determine whether it wants to adopt the alternative model or the supplementary model, so as to make clear the functional positioning of the third pillar pension in advance.
After a model is selected, the next is to mobilize all policy resources to build the 2.0 version of the third pillar. In fact, the pilot program for ax-deferred commercial pension insurance launched in 2018 can be viewed as version 1.0, and the Opinions brought about version 2.0, which further extends the tax-deferred commercial pension scheme from the insurance sector to bank’s wealth management subsidiaries and public funds.
In general, the biggest challenge for China in developing the third pillar pension system lies in how to improve product appeal and channel the huge household savings into the third pillar pension system in the absence of capital gains tax. It is very difficult to attract investors to the market through tax incentives and tax deferral under the condition that OTC securities investment income is exempt from taxation. Therefore, we must take all the tough realities into account and mobilize all policy resources to create a favorable policy environment for the development of the third pillar pension.
This article is based on the author’s remarks at the CF40 Roundtable on Personal Pension System: Policy Design and Market Development on June 24, 2022. It is translated by CF40 and has not been subject to the review of the author himself. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
