As a student in Japan some 15 years ago, it first occurred to me that many words and concepts originating in Europe or the USA had taken on new meaning in Japan. Often the meaning had some connection with the original, but only in a vague sense and, probably due to the passage of time, no longer carried the same connotations as the original.
As an example, the German word “Arbeit” which means work, plain and simple, somehow in Japan referred specifically to the practice of part-time-, after school jobs undertaken by students to earn some extra money. The connection with a decent full-time job had been lost completely. Any German visiting the country and thinking Japanese was not that difficult after all, would have second thoughts after realising how far the Japanese “arubaito” had drifted away from the meaning in his mother tongue. Similarly, “tarento”, although clearly rooted in the English “talent” in Japan refers to TV personalities of the superficial type, often without any obvious talent whatsoever.
It amounts to speculation, but it might well be possible that Liability Driven Investing, also known as LDI could end up to, over time, drift further away from the meaning non-Japanese attach to it and find itself in the company of “arubaito” and “tarento”.
The reason is that many Japanese industry-wide pension funds are appreciating that a large part of their solvency risk lies with them having an investment portfolio that deviates from the portfolio of GPIF and, helped by advice from trust banks and investment managers, are moving to hedge away this risk by replicating the investment portfolio of Japan’s (and the world’s!) largest pension fund, under what is called Liability Driven Investing.
Come to think of it, it makes sense: Japanese industry-wide pension plans carry a big daiko-liability on their balance sheet. This is the portion they look after as agents of the government as it comprises the first pillar pension provision. The actuarially required rate of return on this liability has, after several reductions from the initial fixed rate of 5.5% prevalent until halfway the previous decade, now been set as the return actually achieved by GPIF. This means that to lower the risk of assets not keeping up with liabilities, the most sensible thing to do is: do what GPIF does. Trust banks and investment managers have been fast to offer GPIF-replication strategies to tailor to these clients.
The number of pension funds carrying a “daiko-liability” has diminished compared to the 1990’s when it was a standard feature for all pension funds. In 2003 regulations changed to allow funds to return this portion to the government, an option many corporate pension funds eagerly made use of. Most industry-schemes however could not because the daiko-portion was so big, a return to the government would leave the pension plan with too little assets to provide a raison d’etre, making the daiko-liability a fact of life for nearly 500 pension plans.
The interesting feature is that by using derivatives the GPIF portfolio can be replicated and tracked without putting too much cash at work. This is helpful because many industry-wide funds, carrying very large daiko-portions, are underfunded.
Take the following example: a fund has 1,000 in liabilities, but only 900 in assets (funding ratio: 90%). Let’s assume 800 of the liabilities relate to the daiko-portion (actuarially required rate of return: the GPIF rate of return) and 200 to the second pillar top-up (let’s assume the actuarially required rate of return for this portion is a fixed 5.5%). With only 900 in assets, full cash replication of the GPIF portfolio without using derivatives would use up 800 in assets, leaving only 100 to make the required 5.5% return on 200 of additional liabilities. In other words, the 100 of remaining assets need to return 11% per annum only to keep up (leaving the underfunding intact).
Let’s now assume that the GPIF return can be replicated with derivatives, using only 400 of assets. This means 500 remains available to make 5.5% of return on the additional liability of 200, so all of a sudden only 2.2% of return on the available assets is sufficient. And if the fund can make more (say 2.5% or 3%) it starts to move itself out of the situation of underfunding. In fact, the existence of the daiko-portion, often cursed in the past as an unwanted - and risk-multiplying feature and therefore returned to the government by many corporate pension plans as soon as it was allowed in 2003, in the new context appears like a more benevolent factor: replication with only partial funding works like a reverse lever, lowering the required return on the remaining available assets.
If this is what Japanese-style LDI will look like, it is unique enough to give it a word of its own!