The experience of Japanese pension funds in the 1990s provides an interesting lesson for Western investors, finds David White
There is a Japanese proverb that says ‘if something has happened twice, it will happen a third time’. Could the two periods of deflation - the 1930s in the US (the Great Depression) and the 1990s in Japan (the ‘lost decade’) - be followed by a third? And if so, what are the lessons for European pension funds and their investment strategies?
The economic conditions that led to Japan’s ‘lost decade’ bear striking similarities to the current recession in Europe and the US. By the late 1980s, a combination of high land values and low interest rates had created a bubble in asset prices. In 1990 the Japanese finance ministry raised interest rates, causing the bubble to burst.
The stock market crashed and Japan moved into 10 years of recession. When the central bank tried to correct this by lowering the interest rate from near-zero to zero, the economy became deflationary.
Deflation affects both sides of pension funds’ balance sheet. On the liabilities side, the combination of a fall in long-term interest rates and the impact of deflation increases the present value of pension fund liabilities and reduces solvency levels.
On the assets side, the decline in earnings and the rise in the risk premium hurt investment in equities. Investment in real estate also suffers as investors retreat from real assets into cash.
The management of Japanese corporate pension funds in the 1980s, split between Japan’s trust banks and insurance companies, was in no state to respond to these pressures. In the 10 years between 1985 and 1995, for example, Japanese trust banks achieved a cumulative 59% return on the pension assets they managed, equivalent to a compound average annual return of 4.7%.
By the mid 1990s, returns on pension investment were so low that many company pension schemes became seriously underfunded. A report for the National Bureau of Asian Research (NBAR) in 1998, said that the unmatched pension liabilities of corporations were reaching a critical state and that the pensions of publicly listed companies could be underfunded by up to $400bn.
Part of the problem was the monopoly of trust banks and insurance companies to manage corporate pension fund assets, which blocked any competition from foreign investment managers. This monopoly ended with the 1995 US-Japan Pension Accord, which enabled US firms to compete for the right to manage certain Japanese pension assets As a result, some leading Japanese pension plans, notably Fujitsu and Sony, moved some of their money from domestic to foreign managers.
Government regulations also made pension funds highly risk averse and curtailed their ability to invest money abroad. A key restriction was the so-called ‘5-3-3-2 rule’ which laid down the pattern of asset allocation that employee pension funds (EPFs) should adopt. This regulation, established by the health and welfare ministry, insisted that at least 50% of assets must be principal-guaranteed investments, no more than 30% may be invested in Japanese equities, no more than 30% in foreign securities, and a maximum of 20% in real estate.
The rule ensured that the investment of corporate pension funds was skewed towards low returning, domestic fixed income assets. Figures from the NBAR in 1994 show that more than 37% of Japanese corporate pension assets were invested in fixed income products such as life insurance companies’ general accounts, 26.6% were invested in bonds; and only 17.2 % were invested in Japanese equities.
The 5-3-3-2 rule was abolished in 1997 as part of a wider deregulation of the investment of Japanese pension plan assets that included a move to mark to market asset valuation, and deregulation of the discount rate assumption. Investment policy was aligned with the ‘prudent person principle’ adopted in other parts of the world.
Deregulation gave pension fund sponsors not only the freedom to allocate assets themselves, so as to match their liabilities more closely, but also the encouragement to use asset liability modelling (ALM) as an aid to optimal asset allocation. Guidelines issued by the government in 1997 stated that “the policy asset mix should be reasonably decided using ALM”.
Yet Japanese corporate pension funds were initially slow to take advantage of deregulation. A survey of EPFs by Curuby & Company, a Tokyo-based investment consultancy, found that they were in no hurry to exercise their new freedom.
More than half - 59% - said they would continue to entrust assets to managers within the previous restrictions. Only 28% said they would review their investment policy as a result of these changes. .
Over the longer term, EPFs did move away from the 5-3-3-2 rule towards a less risk-averse investment strategy. However, this did not ultimately resolve the problem of pension fund underfunding.
Hirokazu Maezawa, senior economist at the Japan Center for Economic Research, has compared the investment performance of all EPFs with that of funds assumed to invest in a standard portfolio of bond, stock and foreign currency stock indexes - the 5-3-3-2 model.
He found that up until 1997 - when the 5-3-3-2 restriction was lifted - the performance of EPFs showed smaller fluctuations than the model portfolio, suggesting that up until then they took smaller risks. After 1997, fluctuations were similar or larger (except in 2003) suggesting that EPFs took equal or larger risks than the standard portfolio.
Two factors accounted for the increase in risk. The first was the decrease in guaranteed yields on insurance policies, which fell progressively from 5.5% to 2.5%. As a result, pension funds reduced their allocation of assets to life insurance companies. The second was an increase in the EPFs’ allocation to riskier assets. In 1999, EPF allocation to domestic stocks and other assets, including convertible bonds, increased to 38%.
Unfortunately, the EPFs’ allocation to riskier assets coincided with falling stock markets, the result of both a financial crisis and deflation. This severely affected pension fund performance.
Yet Maezawa suggests that economic conditions cannot be blamed for the underperformance of Japanese pension funds: “The poor investment performance of employee pension funds tends to be blamed on environmental factors such as stock price falls that take place once in 100 years. However, the unsuccessful allocation of assets was actually a key reason for it.”
The investment return targets that the EPFs set were too high, he suggests, with many EPFs targeting annual returns of more than 6%. To achieve these targets, EPFs had to construct high-risk portfolios by increasing their investment in equities.
Yet investment in riskier assets may be the best way to avoid a deflationary spiral. The instinctive reaction of institutional investors in such a climate has been to look for safety in bonds. However, when interest rates are at or near zero, investors are indifferent as to whether they hold bonds or cash. In this situation, the so-called ‘liquidity trap’ deflation is difficult to reverse.
Patrick Artus, chief economist at Natixis, has suggested in a recent research note that if institutional investors are prepared to re-invest in riskier assets they can set off a train of events that can prevent deflation. If, on the other hand, they are prepared to accept low returns on whatever assets they hold, deflation is bound to take root. The latter is what seems to have happened in Japan.
Low returns on real estate and equities in Japan have meant that the overall return on the wealth of the Japanese has been low, he points out. This is principally as a result of deflation. In the face of this deflation, Japanese institutional investors have increased their bond weighting despite the low level of long-term interest rates. They have not invested overseas, even though the return on foreign assets has been far higher than on domestic assets.
In short, Artus says, during the lost decade, the Japanese did not significantly change their risk-averse investment structure in response to deflation, and did not export savings on a large scale, in spite of extremely low returns in Japan.
There are lessons for investors in Europe, he says. The way out of the deflation trap starts with domestic savers. Savers should reject extremely low interest rates and re-invest - directly or through financial intermediaries - in riskier assets to obtain higher returns.
The effect of this would be to increase the demand for risky assets and help prevent deflation. Banks would be encouraged to lend more so as to be able to increase the remuneration of time deposits. Institutional investors would be encouraged to invest abroad or to reinvest in risky assets, leading to a rise in the price of these assets, pushing up demand.
If investors in Europe and the US adopt this course, they may yet give the lie to the Japanese proverb.