India and China, as the two most populous nations on earth, have embarked (albeit at different speeds) on roads that they hope will create wealth on a scale not seen since the Industrial Revolution. With rising productivity come not only rising living standards, but also rising costs of living and rising expectations of the population. While the countries today are focused on immediate problems regarding their current economic slowdowns and the need for financial and political reform, over the longer term one of the most significant challenges both countries will face is the need to provide social security to their massive working and growing retiree populations. Whatever current initiatives both countries have in place or have announced are a drop in the ocean relative to what our calculations suggest is a c.US$30 trillion of combined pension assets both will need in a generation when, as industrialised first world countries, they will need to provide first world services to their populations. Successfully doing so will require enacting significant reforms and putting in place comprehensive systems today. This is no easy task and failure on such an important issue can unravel the success of the past.
The Great Financial Crisis of 2008 has brought to the forefront fiscal issues which much of the developed world faces and has mostly ignored in the hope that growth would fill treasuries with the capital to meet their obligations. In developed countries and developing ones alike, the ageing population and financing the associated underfunded pension and social safety net obligations is one of the most fundamental challenges. China’s demographic challenge is well-known. China, due to its historic one-child policy, has a fertility rate of 1.6 (below replacement levels) and a well-documented looming demographic cliff with its old-age dependency ratio set to increase to close to by almost 4x between 2010 and 2050 (see chart). India clearly does not have the same immediate demographic challenge that China faces – however, by 2050, its dependency ratios will nevertheless rise to 19%, approximately the level of the G-8 today. The dependency ratio alone hides the larger challenge for India – which is that it needs to radically expand coverage and provide improved economic opportunities in order to provide for the future livelihoods of its elderly. In India, 93% of the workforce is employed in the “unorganised” sector comprised of casual workers and labourers, and only 0.4% of India’s population (largely government and public sector employees) is currently covered by some form of pension scheme.
A US$30 Trillion Liability in the Making
The overall potential pension liability for both India and China is significant. If, or some may argue when, they reach the level of development where their populations expect to receive developed country (i.e. G-8) levels of benefits for their retirees, both China and India will need to significantly expand breadth (coverage) as well as depth (investments) in pensions. Perhaps more importantly, each country will need to engage in a more fundamental reform of its benefits system – streamlining delivery of various public and private social and post-retirement benefits while creating effective pay-in systems to channel savings from hard assets (land, gold, etc.) towards financial assets in order to more effectively secure a retirement income. The magnitude of the challenge is clear when comparing India and China’s pension assets to the retiree population (aged 65+), and looking at the net additions to each country’s retiree population over the next four decades (see table and charts).
While the pension systems of rich developed countries, many of which have been developing since the 19th century and those of China and India, which launched their respective schemes in earnest only over the last one or two decades , are of course not directly comparable today, they illustrate starkly the incremental investments China and India will need to make over the next four decades in order to be able to provide a safety net similar to the ones enjoyed by citizens in the developed world today. Factoring in rising incomes, inflation, real GDP growth and shifting demographics, by 2050, China and India would need total pension assets of approximately US$19 trillion and US$9 trillion respectively in order to match the median benefits levels of retirees in the G-8 developed countries today.
At an average 6-7% rate of return, in order to fully fund the future pension requirement, China would need to invest between US$1.5 and US$2.1 trillion today (or 18-25% of GDP); while India would need to fund US$0.7-1.0 trillion (or 37%-53% of GDP) in order to lay the ground for an equivalent safety net to the developed country (G8) median by 2050. Alternatively, a pay-as-you-go system (assuming equal contributions every year) would require additional contributions equivalent to 0.5-0.6% of GDP for China and 0.6-0.7% of GDP for India every year over the next four decades to reach the same funding levels by 2050. Pension expenditure is already the single largest expense of the Chinese government, at US$200bn annually, higher than infrastructure, healthcare or defence, almost 20% of its total budget, (but still only totalling 2.7% of annual GDP), with coverage provided to less than half of the population above the age of sixty. India’s government already invests US$12bn annually (6% of the annual budget but under 1% of GDP). Nevertheless, the country’s pension coverage is in its nascent stages with most of the population yet to be covered – therefore both countries will need to significantly step up their pension investments.
Filling the Gap
Filling the gaps in the pension systems will require augmenting or significantly reforming existing social security systems. China is currently aggressively augmenting its social safety net – between 2009 and 2012, China has expanded coverage from 30% of the population to 55% (or 664mn people) currently. Clearly, China’s leaders are not only aware of the demographic cliff which it faces as a result of its historic one-child policy but are taking steps to address the challenge. This includes a rural pension plan which has signed up 240mn people since it was introduced. Our simple calculations suggest that the challenge may require even more aggressive steps. While the demographic outlook for India is more sanguine than China over the next several decades, the larger issue which India faces is the low levels of current domestic pension coverage and investment. While government employees and organised private sector employees have access to a variety of pension plans, most informal labourers and agricultural workers continue to live on a subsistence income (India’s poverty rate, or the percentage of people living at subsistence levels is estimated at 37% by the World Bank) without any form of formal coverage. However, despite their unique demographic, macroeconomic and political challenges, both India and China face a similar set of imperatives in providing for their future retiring populations. These include:
- Creating Funding Pool Today. With rapidly evolving demographic structures and rising dependency ratios, both India and China will be better served by creating a much larger corpus of funding for pension and social safety net obligations today when their demographics and economies have the level of savings needed to fund future requirements. A ‘pay-as-you-go’ system will simply increase the funding requirements for each country’s future retirees, with liabilities growing inversely to the number of payers over time. For example, in China’s currently hybrid system (which has a pay-as-you-go component) provincial governments have been forced to take from individuals’ defined contribution accounts to pay benefits to current retirees, leaving current payers accounts underfunded. Without creating a significant pension corpus today, China will face increasing pension funding pressure, while India faces a more fundamental problem of expanding coverage to a large under-employed population.
- Fully Utilising the Private Sector. Both countries need to significantly expand coverage for non-government workers – and have taken only piecemeal steps in this direction. For example, India has opened the government pension scheme (NPS) to the private sector – however with most non-government employees being part of the unorganised sector, there is limited incentive for companies to provide these benefits. In addition, rural agricultural workers comprise a large number in both countries – but particularly in India. Pension and insurance regulators in both India and China need to invite the private sector to participate in the pensions sector in a meaningful manner by offering incentives which enable them to develop innovative savings products and services to deliver benefits, for example, by inviting private sector insurers and asset managers to set up pension funds and promoting foreign investment in these sectors. They also need to offer similar broad-based incentives to individuals for long-term savings whether through a government or private plan.
- Expand Systems and Channels for Coverage and Delivery. Between the two countries combined, they will need to provide coverage for over a billion additional people who do not currently enjoy a pension over the next few decades in order to reach close to the coverage levels of developed countries. Social security and benefits to the poorer sections of the population are the most essential and both countries need to invest in financial inclusion in order to reach the ‘un-banked’ portions. No developed country has had to provide a social safety net of this scale. Doing this will require far more innovative channels for both savings and delivering benefits than any current precedent in the developed world. Recent experience indicates that governments can play an important role in promoting financial inclusion – for example in India by promoting the microfinance sector to deliver additional pension and social security products, while continuing to invest in the unique identification program which will enable e-banking and direct cash transfers to benefit recipients.
- More and Better Financial Savings Schemes. Both India and China will also need to further liberalise current capital account controls in order to provide better options for financial savings to their citizens. For example, in China an average private investor has limited long-term investment options beyond speculative real estate, bank deposits with negative real interest rates, and an illiquid and un-transparent domestic equity market. India, although it has created more flexibility for its citizens to invest abroad , still finds itself in a situation where a majority (56%) of domestic savings are invested in physical assets like land and jewellery instead of financial assets. Without these fundamental reforms, it will be difficult for either China or India to finance the investments anywhere close to the scale outlined above.
- More Balanced Wealth Distribution and Incentives to Save. While both countries enjoy a comparatively high savings rate relative to developed countries (see table), the wealth distribution remains skewed with a relatively large portion of people living at or below the poverty line with limited discretionary income. Moreover, this capacity to save will diminish as their respective population age and economic affluence boosts consumer spending. A more balanced wealth distribution, through better economic opportunities for the poor combined with incentives to save, will ensure that both countries are able to provide a reasonable social safety net for those who need it the most.
The five requirements outlined above represent a revolution in the scope and scale of the equity markets and the mutual fund industry. Clearly, it is a far reaching strategic decision to embark on such a programme of change. However, there are few relevant alternatives that have shown success in any part of the world.
It’s Not Just About Pensions
While expanding coverage and financing the social security net may not appear as imminent a threat in India and China as it does in the developed world today, the sheer scale of the demographic and the investments required imply that it is a challenge which neither country can afford to ignore. More broadly “Our people … wish to have better education, more stable jobs, more income, greater social security, better medical and health care, improved housing conditions, and a better environment…To meet their desire for a happy life is our mission”
Xi Jinping, The unveiling of the new Chinese leadership, 2012 though, pensions are only a part (albeit an important one) of the social security systems their citizens will increasingly demand. Healthcare is another major part of the equation obviously, as well as broader welfare such as unemployment benefits, basic education, low-income housing and even food security. In many of these areas China and India’s current systems are rudimentary or practically non-existent. Expanding these programs on the same scale as its pension systems will not only require capital, but a fundamental build-out of infrastructure to build rural healthcare delivery and schools and investments in education to train tomorrows’ teachers and medical practitioners.
Success Requires Institutional Change and Sustained Economic Growth
Creating these systems at developed world levels in India and China will require a fundamental macro-economic shift combined with social, political and regulatory reform. China’s historic one-child policy which has created the demographic issue and will make it worse, and India’s labour laws which have perversely created an under-employed, “It has become necessary that we have modern systems of social security in place for the elderly. The absence of adequate public healthcare facilities and the rising cost of private healthcare make it imperative that social security be provided.” Prime Minister Manmohan Singh at
Launch of Indira Gandhi National
Old Age Pension Scheme, 2007 largely-agricultural, and informal labour pool are examples of fundamental reforms which need to be undertaken with urgency given the sheer scale of the challenge. The implications for governments, retirees, investors and other stakeholders are clearly significant in terms of the creation of comprehensive state and private pension plan, regulation of these plans, development of public and private institutions that can manage these sums transparently, the role of domestic and international fund management institutions, taxation policy and the knock-on effect on monetary policy. Ultimately, though, developing first world-level social security systems will require a shift in the mind-sets of India’s and China’s societies as a whole to one where the society feels its success is measured by the way that they treat their worst-off and the economic opportunities which are made available to them. As the story of the passage of the US Healthcare Bill under the Obama Administration has shown, the role of the state versus the private sector in the delivery of benefits and even the delivery of benefits to those that cannot afford them is a significant challenge even in the America culture. European cultures do not have such a big issue on this matter. If India and China hope to build “first world” economies and societies within the next generation and especially if they wish to maintain stability in a world of rising expectations, they cannot afford to delay adopting policies and creating a system, private and public, that delivers.
1. The old age dependency ratio is defined as the ratio of retirees (age 65 and older) to people of working age (15-64)
2. This simplified analysis does not fully-capture certain benefits obligations in developed which have been committed to retirees but are not fully-funded. The analysis also implicitly assumes that India and China in 2050 will have similar purchasing power and life expectancy to developed economies today
3. Ratio of Pension Assets to Income calculated as Average Pension Assets per retiree / Nominal per Capita Income; Assumed ratio used for calculations is based on the median figure for G8 countries;
4. Implied Pension Assets in 2050 calculated as Number of retirees in 2050 x Implied Pension Assets per Retiree
5. China outlined a new national basic pension insurance system in 1997 while India launched the National Pension Scheme in 2004;
6. The Society of Actuaries uses the Citigroup Pension Liability Index (CPLI) which tracks the long-term pension discount rate. While the discount rate for pension plans is currently 4.8%, since Citigroup began tracking it in 1995, the average discount rate has been 6.4% and it has largely been in the range of 6-7% during the period.
7. Indian citizens are allowed to invest up to $200,000 outside India subject to certain restrictions
Creating Prosperity for a Billion People: Re-architecting the System of Wealth Creation