Looking back on 2012, the year has been even more of a watershed year for the Japanese occupational pension system than was already foreseen in the past.
The abolition of Tax Qualified Pension Plans after 40 years in existence by March 2012 didn’t come as a surprise to anyone: the Defined Benefit Corporation Pension Act that contained the abolishment of this arrangement, where companies save for their employees retirement income directly on their balance sheets, dates back to 2002 and corporations with a TQPP have made switches to other pension arrangements well ahead of time.
The change in the profile of the average pension fund from a net receiver of premiums to a net payer of benefits was also long in the making. The baby boomers born in the 1946-1949 period reaching their pension age around now is one of the few certainties for which a pension fund can plan well in advance. But even so, the fact that since this year - on average - pension funds are net cash-negative will have a significant implications for their ability to absorb negative shocks and –as a result- their investment policies.
The implementation of a change in accounting rules towards bringing the pension deficit fully on balance-sheets and towards reflecting any fluctuations immediately into the profit and loss statement, initially targeted for this year, has been postponed to 2014, but many corporate pension funds have this year taken measures in anticipation. Not only are corporate sponsors now more conscious of the liability profile of their pension fund, some are actively changing it by moving a larger chunk of their pension promise to defined contribution to dampen the impact of the accounting change.
The sudden announcement early November that, in the wake of the AIJ fraud, the Ministry of Health, Labor and Welfare is aiming for an abolishment of the Employees Pension Fund (EPF) system however will have taken many by surprise.
To refresh memories: the EPF structure is the one where a pension fund manages and pays out a portion of the first pillar government pension (called the “daiko portion”) in addition to the second pillar pension promise made by the employer on top of the first pillar benefit. The system dates back to the 1960s when this mixing of public and private pension was deemed necessary to get buy-in from employers to provide for a decent pension benefit in the first place and thus make the system as wide-spread as it is today. It also served to give the pension plans the necessary size to reach scale efficiencies in the administration and investment management of the plan. Lastly it gave comfort to participants the government had a stake in this important social arrangement.
In the 70s and 80s the system was a great success, spurred by tax-incentives and – not the least - the 5.5% assumed return on investment, which turned the funds into cash-cows for corporations because the yields on government bonds was high single digits and equity markets were booming (from 1965 till 1985 the average pension fund’s investment return was 10%). The 5.5% however turned from a blessing into a curse when stock markets tanked after the property and stock-market bubble burst in 1989 and as Japan entered its lost decade(s) of ultra low interest rates. When the government, in 2002 allowed plans to return the “daiko-portion” and move to a pure private pension plan, only the larger corporations could afford to do so. Many smaller, industry-wide schemes did not have the assets to meet their daiko-liability or would be left with too small a scale to continue operating, so the current universe of 577 EPFs (down from 1656 a decade ago) consists mostly of medium to small sized sector funds, each consisting of a large number of SME participants, often in financially constrained, declining industries.
Some say the 5.5% required return played a role in driving some EPFs into the hands of AIJ, the Japanese Madoff, responsible for ¥200bn ($2.5bn) of pension fund losses. About half of the EPFs now have less money in the bank than the amount of their daiko-liability, the hole is reported to be ¥1.1trn (EPF’s have ¥27trn of assets, so it amounts to around 4% of the size of the system).
The Ministry now wants the EPFs in most trouble to dissolve during a 5 year time frame and abolish the EPF system altogether by 2022. The proposal for making up the ¥1.1trn hole is to first try to have the SMEs participating in the EPFs in question to make up the difference through additional contributions, but if this fails (as it is likely to) pension premiums paid by non-related employees will be used for the purpose.
The question whether the Ministry’s plan will actually be implemented will depend on the politicians. The LDP is expected to recapture a majority if and when Prime Minister Noda dissolves parliament and calls new elections; they are said to favour a continuation of the EPF system. Many opinion leading commentators are concerned: what about the rights of participants and pensioners to the + alpha portion of the EPFs to be dissolved?; what about the EPFs that have been well-managed and remain well funded? ; what about the macro economic impact of tinkering with 4.4mln participants’ retirement security; how to avoid a sell-off in stock prices similar to the previous period of daiko-restitution in 2002 ? Clearly 2012 will be a year to remember in Japanese pension circles, whether in a negative sense, or ultimately as triggering a positive change, remains to be seen.
Oscar Volder CFA is Head of Institutional Sales at BNP Paribas Investment Partners Japan