Crisis in the Japanese pensions provision is providing new opportunities for investment advisers, as major corporates rethink their strategies. George Curuby reports
Mounting pressure on Japanese plan sponsors has resulted recently in a torrent of new mandates for investment advisers. The fundamental problems of sponsors are being exposed by the lacklustre Japanese investmentenvironment and the inability of Japanese trust banks and life insurers, traditionally balanced managers, to meet the 5.5% assumed rate of return mandated by the government for pension funds.
Adding to the pressure is the fact that from March 1998 assets will be valued on a market basis, making it more difficult for corporate sponsors to hide a plan’s condition from shareholders. Yet more anxiety comes from a recent move towards introducing FAS 87 type accounting standards. An indication of the scale of the hidden problem comes from the 24 Japanese companies with American depository receipts (ADRs) which already provide FAS 87 format reporting. As of March 1996 they had combined pension assets of $40bn but were underfunded by $27bn. The extent of their underfunding under Japanese accounting standards was minimal.
With the Japanese stock market in a slump, earnings under pressure, returns on pension assets down, and the integration of plan finances with overall corporate finances under way, it is inevitable that pension plans are starting to gain the attention of senior executives. A recent report from Daiwa Research Institute estimates that the companies listed on the first section of the Tokyo Stock Exchange would be underfunded by a total of $140bn if they applied FAS 87. So plan sponsors are rushing to give specialist mandates to investment advisers offering annualised yen-based returns above 5.5%.
About $60bn shifted from insurers to trust banks and investment advisers in the six months to April 1996, after which life insurers reduced their guaranteed return to pension plans from 4.5% to 2.5%. Of this $50bn was from public and $10bn from corporate plans.
The pension market has therefore become important for investment advisers, who have had limited access to it since April 1990. At the end of September 1991, advisers collectively managed only $18bn in pension assets. Five years on, this figure had grown to $115bn, of which $79bn came from public plans and $36bn from corporate plans. Domestic pension assets now account for almost 40% of assets managed by investment advisers for Japanese clients, and foreigners have captured a 16% share of these assets.
Over the next 10 years industry insiders expect advisers to win at least a 25% market share of corporate employee benefit plans, whose assets are projected to double in size from $384bn to $768bn. Foreign-affiliated advisers, of which 18 firms had a total of 150 corporate pension mandates, have already made considerable headway, with total assets of $6.3bn at the end of September.
The main segments of the Japanese pension market total about $2 trillion in assets, of which $1.5 trillion is public and the remainder corporate. Of this total, about $890bn is given out to third-party managers.
There are two types of corporate plans: employee benefit ($384bn) and tax-qualified ($169bn). Tax-qualified plans are not yet allowed to use investment advisers, something both advisers and plan sponsors are unhappy about. In the next few months, the US and UK governments will be bringing pressure to bear on this, as they have done on other pension market access issues over the past decade. We expect that by the end of 1997 tax-qualified plans will be allowed to use advisers for specialist mandates.
As a result of US pressure, advisers have been allowed since spring 1996 to manage the moneys of the Pension & Welfare Service Corporation. Often referred to by its Japanese acronym Nenpuku, this is a public entity managing $230bn in public pension assets. Before then, advisers could only manage assets of the 11 major public plans known as mutual aid associations, totalling $405bn. Morgan Stanley and Goldman Sachs were the first two foreign firms given access to Nenpuku moneys. Since April, numerous Japanese and foreign advisers have received mandates, with a total of $50bn shifting from insurers to advisers and trust banks in 1996. This bonanza from Nenpuku is not expected to become an annual event, however, and there are even proposals circulating about privatising this and other public plans.
The pace of new business has quickened recently, particularly in the corporate sector. During the first nine months of 1996, advisers added 577 corporate and 73 public mandates, with an increase in assets under management of $15bn and $40bn respectively. The financial press would lead us to believe that advisers will capture market share of the magnitude they did in the ERISA market in the 1970s and 1980s but it is still unclear whether this gold rush will turn into a gold mine.
The shift towards investment advisers is the product of a long season of discontent among plan sponsors. They are unhappy with the returns they have been getting recently from their traditional managers and the limited disclosure of portfolio holdings due to the commingling of most accounts. In recent years the specialist services of investment advisers have outperformed in absolute terms the generalist/balanced services of traditional suppliers. Advisers also provide their services through segregated accounts with full disclosure, which adds to their appeal.
Few Japanese sponsors are yet up the learning curve about modern portfolio theory. Traditionally they have given out multiple balanced mandates similar to in the UK rather than a collection of specialist mandates in line with an asset class mix they determine, as in the US. Until recently, the assets of each manager’s portfolio were restricted by the well-known 5-3-3-2 rule. Since early this year it has become possible to appoint managers for specific asset classes as long as the 5-3-3-2 asset class restrictions are observed at the plan level.
A major hindrance of structuring portfolios appropriate to a plan’s liabilities is the limited disclosure of portfolio holdings by trust banks and insurers and the fact that reporting is only on a book value basis. Consolidated, frequent reporting at an individual security level by master trustees, as is common in the US, is not available in Japan. There are also human resource constraints. Most corporate sponsor staff lack investment/finance skills: they have personnel department backgrounds or are former Ministry of Health and Welfare officials. One major Japanese plan sponsor recently asked a US counterpart if 25 external managers was too many. The reply - It depends on how many asset classes you want to be in” - was not understood. So consultants and advisers still face a considerable educational task before sponsors give out specialist mandates for appropriate reasons.
In the short term, we believe specialist mandates from the sponsor’s perspective will represent a short-term fix to underfunding rather than an attempt to move out on the efficient frontier. The current spurt of interest in advisers does not yet signal a long-term change in sponsors’ investment behaviour. In the long term we expect plan sponsors to rewrite their social contracts with beneficiaries, revise defined benefits downward, and introduce a defined contribution system (which does not yet exist in Japan).
For the time being, manager selection will focus on three categories. We expect the larger plans (the primary users of advisers) to place 40-50% in the GICs offered by insurers, 20-30% in balanced mandates with Japanese trust banks, and the remainder in specialist mandates with advisers. As such, they will initially view managers in terms of three risk-return categories rather than try to combine them through a core and satellite arrangement using asset/liability management models.
Pension consultants are playing an increasingly important role in Japan. There are only a few experienced professionals because once they develop a stable of clients they tend to be poached for marketing assignments with investment advisers. At present, Frank Russell, Watson Wyatt and the Japan Bond Research Institute are the leading consultants. The number of consultant-generated mandates is increasing, and we expect plan sponsors to use them more for manager searches in future.
Optimists inside advisory companies expect a sea change in the use of external managers. Staff in Japanese trust banks and life insurers, on the other hand, tend to see it as a fad arising from frustration. Those staff we have recently spoken to are only mildly concerned about advisers’ recent gains.
In theory, the nine foreign-affiliated trust banks should be ahead of the foreign advisers in the corporate sector because they entered the pension business in 1985. Their banking licence also gives them full access to all segments of the pension market and their investment skills enable them to offer both balanced services like Japanese trust banks as well as specialist services similar to advisers. However, the table shows that only three of the top 10 foreign managers of corporate pension assets are trust banks. In our opinion, foreign advisers have rapidly gained ground over foreign trust banks because they have a clearer image as specialists at a time when the plan sponsor community is in crisis and sees “specialist” management as a panacea for its problems. This has contributed to the recent decision by JP Morgan and UBS to add investment advisory subsidiaries to their existing trust bank operations in Japan.
In our opinion, the big challenge for traditional managers will not come from sponsors shifting to advisers as they change from a fixed rate of return to a market return perspective. It will come from the shift which is just beginning to happen from active to passive management techniques. As one well-known member of the US plan sponsor community, Robert Shultz, said to a group of Japanese sponsors at a recent International Pension & Economic Research Institute seminar in Tokyo, “If you can’t control the markets, control costs.”
Once Japanese sponsors start to use market benchmarks for measuring their managers and see how difficult it is for active managers to add value to indices, we expect a move towards passive products due to the inherent cost-consciousness of Japan’s corporations. This trend, whose first evidence is the recent rise of Barclays Global Investors in the pension asset management league charts, will present opportunities for managers such as State Street, NatWest, and other foreign firms who have not yet offered quantitative services (and commission recapture programmes) to Japanese plan sponsors.”