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Investment skills move to fore

Japanese private pension plans have been growing rapidly since they were established in the 1960s, reflecting the maturity of the domestic demographic structure. Their combined assets amounted to around ¥100trn (n930bn) as of September 2000. There are two types of private pension plans in Japan; ‘Kosei-nenkin-kikin’ and ‘Zeisei-tekikaku-nenkin’, of which the former is the major one. Since the two systems have been regulated by different authorities, they are exposed to similar but different regulations. This article will mainly describe the history of the change in regulations and money manager selection practices for the Kosei-nenkin-kikin.
Initially, only domestic trust banks and life insurance companies were allowed to manage the assets of Japanese private pension plans. Trust banks typically pool pension funds assigned to them and manage them in a segregated account called a ‘pension trust fund’. Currently, pension trust funds comprise more than half of domestic private pension assets.
Life insurance companies tend to commingle assets from various sources, including life insurance premiums and pension assets, and manage them in a single account called a ‘general account’. For pension plans, the returns from pension trust funds vary reflecting actual asset management results, but those from general accounts of life insurance companies are fixed at a preset rate. The nature of the latter product is quite similar to that of a GIC (guaranteed investment contract).
The restriction on the types of money managers was quite consistent with Japanese national policies to activate domestic industries due to a two-step rationale.
First, the Japanese government classified domestic financial institutions into long-term and short-term financial intermediaries. Trust banks and life insurance companies were classified as the former. Second, private pension assets with a long-term nature were controlled to flow into these long-term financial intermediaries, with the expectation that they would ultimately flow into firms in politically important industries as long-term loans.
The asset allocations of pension trust funds and life insurance companies are shown in Table 1 and Table 2, respectively. In 1970, several years after the establishment of private pension plans, around 80% of pension trust funds were loaned, while 63% of the assets managed by life insurance companies were allocated to loans. However, the allocations to loans have been significantly declining, particularly with pension trust funds, where most assets have been recently invested in domestic and foreign securities. On the other hand, loans are still the largest asset category for life insurance companies, comprising around one third of their assets.
In addition to the regulation on the types of money managers, a strict restriction on asset allocations was imposed for private pension plans by the end of the 1970s. In particular, the ‘5:3:3:2 regulation’ for pension trust funds was established. Under this regulation, the asset allocation of each trust bank was required to conform to the rules shown in Table 3. The regulation was enforced until the middle of the 1990s, which limited trust banks’ decisions on the asset allocation of their pension clients until recently.
Due to the pension trust fund regulation and the fixed-income nature of contracts with life insurance companies, money manager selection was not considered to be a critically important decision for pension sponsors since any combination of money managers provided similar investment results. As a result, pension plans tended to choose money managers based on factors unrelated to their asset management abilities and often emphasised a variety of business relationships when choosing asset management companies.
Throughout the 1990s, there was a general trend to deregulate Japanese private pension markets, which seems to reflect the recognition by regulatory authorities that pension assets have to be managed as efficiently as possible, based on their funding situation and liability structure. In 1990, investment advisory firms were allowed to enter the market and in-house asset management became possible. In 1996, the original 5:3:3:2 regulation for each money manager was abolished and replaced with a new 5:3:3:2 regulation for combined assets of each pension plan. This regulation was terminated in December 1997. Since then, Japanese pension plans have been urged to independently determine their asset allocation policies, therefore money manager selection has become one of the most important decision making processes since it significantly affects the investment performance of their assets.
The deregulation in the Japanese private pension market has the following important implications.
First, investment skill has become the most important factor in the manager selection process. Before the deregulation, plan sponsors tended to select money managers with close business relationships, such as their stockholders, bondholders, and/or sellers/buyers of their products. Nowadays, such a selection practice would be unacceptable.
Second, after the termination of the 5:3:3:2 regulation, manager selection based on some specialty has become possible, although selecting balanced managers was only feasible before the deregulation. Currently, plan sponsors can select money managers with any kind of strength and make special requests regarding asset classes and management styles when allocating their assets.
Third, although a combination of several active managers with different management styles was previously more popular, some plan sponsors began to adopt more advanced manager selection schemes, where passive core managers and specialised active managers are combined. Since most domestic trust banks can now follow any benchmark portfolio quite precisely, many plan sponsors are using commingled passive funds provided by trust banks as their passive core portfolios.
Finally, plan sponsors are now interested in alternative investment products such as private equity funds and hedge funds, mainly because most traditional assets are not as attractive. Many money managers, particularly international ones, are actively promoting their alternative products. However, very few plan sponsors have actually invested in these products due to their lack of knowledge and conservatism.

Generally speaking, Japanese pension asset management has not been exercised exclusively for the benefit of plan participants. Instead, it has been strongly affected by other factors such as national fiscal policies and corporate capital policies. This situation will likely continue for the time being.
Due to uncertainties surrounding private pension markets, a reduction in pension liabilities is now one of the most important concerns for plan sponsors. Under the current system, private pension plans are managing part of the national pension assets for their beneficiaries on behalf of the Japanese government. Plan sponsors may return this portion to the government if a new pension law passes in Congress.
The Japanese government is expected to allocate a significant portion of the returned assets into fiscal bonds, instead of corporate stocks, reflecting the huge Japanese fiscal deficit and the need to raise new funds by issuing fiscal bonds.
In addition, another new law under consideration may introduce defined contribution (DC) pension plans, where each beneficiary determines the asset allocation of his or her own pension account. The new system would favor many plan sponsors since it limits uncertainties on future pension liabilities. Reflecting uncertainties surrounding the Japanese business environment, many Japanese companies cannot afford to contribute additional funds to DC plans. Therefore, the conversion of existing retirement income funds would be the most probable solution for the majority of Japanese companies. It is expected that most new plans will be invested into safety assets or balanced funds such as lifecycle funds. The portion of corporate stocks will likely be limited mainly due to the conservative nature of Japanese people.
After the deregulation, in particular the abolition of the 5:3:3:2 regulation, Japanese private pension plans increased the equity portion of their assets. Due to the aforementioned unique features in the Japanese pension market, the average asset allocation of Japanese pension plans will continue to be more conservative than those of US and European counterparts for the time being.
Rikuro Sakai is senior analyst and Masashi Toshino is senior researcher at Daiwa Institute of Research in Tokyo

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