(Repinted from HKCER Letters, Vol. 17, November 1992) 


On Retirement Protection in Hong Kong

Francis T.M. Lui


The government put forth the Consultation Paper on A Communitywide Retirement Protection System last October to solicit public opinion on the matter. Since then, attention has focused mainly on whether the government should act as the ultimate guarantor for the pension funds. It has been pointed out that since the scheme is mandatory, the government should take the responsibility to protect the retired. If, as a result of the guarantee, a lot of funds would flow to high-risk investments, regulation can always be used to alleviate the problem. However, as the following discussion would show, it is not advisable for the government to guarantee pension funds.

To begin with, it is necessary to note two ideas relevant to the discussion here. First, it is common sense that investments with higher expected returns usually involve higher risks. If people are free to choose, they will invest in items with the expected return and risk they prefer best according to their wealth, degree of risk aversion, and so on. It is not fair to require everybody to put his funds in items of a given risk level.

The second issue is that of moral hazard. As long as employees know that their investments are guaranteed, they will mostly opt for those pension funds with high expected returns. Pension funds, in turn, will opt for those investment items with high expected returns (and therefore high risks) so as to attract more business. As a result, the communitywide investment risk rises correspondingly. The possibility of financial crisis and government budget crisis will also increase.

With the above understanding, let us discuss briefly seven possible schemes of retirement protection. The first is similar to the one proposed recently by the government. The government does not provide guarantee of any sort, except some basic supervision to avoid fraud. This scheme does not induce moral hazard, but leaves the employees to face investment risks themselves.

The second scheme is one in which the government acts as the guarantor of pension funds. The problem here is obviously that of moral hazard. The average risk of investment in society will be higher, with possible adverse effects on the government budget. Some may think that this moral hazard problem can be avoided if the funds are regulated in terms of the kind and degree of the risk they can take. This is the third scheme and is widely supported within the Legco. Yet its shortcomings have often been overlooked.

It is necessary to have regulations on pension funds to cut down on fraud, and other rules such as minimum capital requirement. It is, however, inappropriate to restrict the kind of investments these funds can make. Rules that confine investments to some given risk levels may not cater to the preference of individual employees. In addition, such rules usually set too low a level of acceptable risk, resulting in investments that are too conservative, with too low rates of return. Low returns would in turn raise the risk of insufficient protection after retirement.

Another problem with regulation is that the market can often come up with new ways of operation to bypass the regulations, as witnessed by experiences in other countries. New rules on investments, once they come out, are effective in reducing moral hazard. However, it would not take too long for investors to develop new financial instruments that allow them to get back to higher risks. Certainly the government can revise old rules to cover the new instruments, but again, it is doubtful that they will remain effective for long. Successive regulations can be highly damaging to the outcome of investment, which is not what the public would prefer.

The fourth scheme is the central provident fund. Since the government takes care of the investment, most employees would perceive that their money is more or less secured. At least the government can resort to higher taxes or other means of transfer to make up for investment losses if any. However, as a matter of fact, entrusting money in the government is not entirely riskless. Governments can also default, as may be the case in times of political crisis. Yet, the main weakness with a central provident fund is lack of competition. There is little incentive on the part of government officials to seek good performance of the fund they manage. Their main concern will simply be to make sure the fund remains solvent.

The fifth scheme is the pay-as-you-go system. This is close to what has been suggested by some as a communitywide protection scheme, and is a common form of retirement protection in other countries. The main feature of this scheme is that the government taxes employees today to pay the retired today. In other words, what an employee gets when he retires in the future depends on the amount the younger employees pay in the future, and is hardly related to what he pays today. Such a scheme may have detrimental effects on economic growth. According to a recent estimation by this author, should this scheme be adopted, the annual growth rate of Hong Kong could be lowered by as much as 0.36 percent. The accumulated loss in a 30- or 40-year period could amount to 2,000 billion Hong Kong dollars (after adjustment for inflation). This pay-as-you-go system is so economically damaging that it is not worth adopting. (Readers can refer to another article by this author in the November 1991 issue of the HKCER Letters for further discussion on this topic.)

The sixth scheme is simply to maintain the status quo, that is, no mandatory retirement protection. As a matter of fact, a mandatory retirement protection system may not necessarily raise the overall savings rate of the community. There are no statistics on savings in Hong Kong, but it is quite obvious that residents here do save quite a high percentage of their disposable income, as witnessed by the amount of wealth owned by the average household. A mandatory retirement protection system would merely replace existing private saving and investment with pension funds, without necessarily increasing the amount of protection after retirement. If at all, the benefit of having such a system is to avoid another kind of moral hazard: People may save very little now, in the hope that they can force the government to provide welfare to them when they get old.

The seventh scheme is what this author subscribes to. There is a mandatory retirement protection system, but the government's role is confined to the very basic supervision. It does not restrict the activities of the pension funds, nor does it make any kind of guarantee with respect to their performance. In addition, several other things have to be instituted. First, financial companies can provide various types of pension funds, those with high return and high risk, as well as those with low return and low risk. Second, they have the responsibility to make it known to the public updated information on the performance and risk of all the funds they provide. Third, except for some long-term investment, the public can freely switch its retirement account from one pension fund to another, either within the same financial company or another company. The only restriction is that people cannot cash in on their accounts until they retire. These provisions let the public choose the combination of risk and return it prefers best. The people themselves have to face the risk they select, but the risk can in general be reduced since they can diversify by holding various funds at the same time. Given that the public can choose and switch funds, fund managers are subject to competition and are driven to provide good financial services.

There have been tremendous and repeated evidence that the market outperforms the government when it comes to economic activities. The provision of retirement protection is unlikely to be an exception.

Dr. Francis T.M. Lui is a senior lecturer in the Department of Finance and Economics at The Hong Kong University of Science and Technology.


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