Demographics has already started to strain state-run and private retirement systems worldwide, as shrinking number of workers find themselves supporting an increasing number of retirees. But nowhere in the world are these pressures as acute as they are in Japan. Japan’s collective retirement provision obligations will remain 49% underfunded by 2002 and 44% underfunded by 2005, the first year that post-war baby boom Japanese are eligible to retire.
Japan’s own particular demographics has helped cause this problem. The Organisation for Economic Cooperation and Development predicts that Japan’s already low support ratio – the number of working-age population divided by the number of retired citizens – will be the world’s fifth lowest by 2030. But the ratio will have dropped more than 60% from 1990 levels, representing the largest such decrease anywhere in the developed world. A substantial increase in the projected proportion of Japanese aged 65 or older will create the primary pressure on the support ratio.
The fall in interest rates held dire consequences for the nation’s social security and occupational pension schemes. Severe asset allocation restrictions throughout most of the 1990s forced Japanese state and private sector pensions to invest in the asset classes most damaged by the fall in interest rates. The social security system had to invest most of its assets in government bonds and infrastructure loans. Occupational pensions, by law, had to place half their assets in domestic fixed-return instruments.
As a result, the yield on aggregate pension assets in Japan began to drop below the 5.5% actuarial assumption that the government required for all pension benefits. (Some argue the 5.5% yield was difficult to achieve even before the bubble). One of the key barometers of Japanese pension provision has been the “floor rate” that life insurers have guaranteed for pension assets invested through their general account portfolios. In 1994, several life insurers announced they would drop their floor rates to 3.5% from 4.5%. In 1996 rates plunged to 2.5%. In April 1997, the government finally admitted the severity of the situation and abandoned the obligatory 5.5% return for employee benefit plans. By the fall of 1999, most floor rates sat at 1.5%.
Matters haven’t been helped by the investment policies of the Fiscal Investment and Loan Programme (Zaitoh in Japanese), which handles most of the Japanese social security system’s assets. Zaitoh has come under fire from several quarters for ineffective management and bad business decisions.
Demographics and lacklustre investment policies are both affecting the social security system. Under current conditions, expenditures will eventually outweigh contributions to both the universal and earnings-linked components of the first pillar scheme. Some researchers are forecasting a ¥328trn deficit by 2060 at current contribution rates.
Like their counterparts around the world, however, Japanese politicians have been loath to reduce social security benefits and raise contributions. The ministry of health and welfare has been relatively successful in its drive for social security reform.
The occupational pension fund sector also faces an asset-liability gap caused by asset allocation restrictions and plummeting interest rates. Those unfunded liabilities will become painfully apparent during the fiscal year 2000, which ends in March 2001. During the past 12 months, Japanese corporations must implement new accounting standards, roughly equivalent to the US Financial Accounting Standard 87, which isolates pension assets and liabilities within the obligatory balance sheet and forces businesses to reveal their pension holdings at market value. (Internally, pension funds already have been ordered to shift from book value accounting to market value accounting, as well as to adhere to a loophole-filled minimum funding rule, beginning in April 1998).
Currently, Japanese accounting makes it difficult to gauge the corporate sector’s unfunded liabilities. One key indicator is the boom over the last two fiscal years in the number of Japanese corporations making extraordinary contributions from earnings to ease pension deficits.
The Japanese are aware of the crisis (although most are unaware of its magnitude). Many are now earmarking a growing portion of their personal savings for retirement. But most still place their personal retirement savings in low-return, low-risk instruments that will fail to cover the gap between their post-retirement income needs and their state and occupations pensions.
Some Japanese observers have played down pension under-funding by arguing most liability calculations fail to account adequately the lump-sum retirement payments allowed under Japanese law. Retirees have traditionally favoured lump-sum payments, taxed at one-fourth the marginal rate, opposed to fully taxable annuity pension distributions. Such payments would reduce projected liabilities by decreasing the annual retiree benefits for which a plan would remain responsible. Some Japanese pension experts argue that once lump-sum payments are accounted for only 50% of Japanese corporate pension plans have unfunded liabilities.
However, such counter-arguments are losing strength. The proportion of retirees claiming their benefits as annuities rather than lump sums has risen from 10% to between 40% and 50% in the period from the early 1990s, according to several sources. As actuarial assumptions still exceed prevailing interest rates, many Japanese conclude a pension annuity can offer more money than self-invested retirement lump sums could ever provide. Many now believe that differential outweighs any tax incentives they might receive for accepting the lump sum.
Corporate plan sponsors – particularly steel and heavy industry companies, which are facing the largest unfunded liabilities – are already taking several steps to alleviate their pension provision burden. After the government removed the required 5.5% actuarial assumption, many plan sponsors reduced their annualised benefit returns, much to the consternation of Japanese unions.
Many employee benefit plans are also clamoring to “contract in” to the social security system. In return for receiving part of an employee’s social security contribution, employee benefit plans have assumed part of the responsibility for providing the worker’s final social security benefit. Contracting in would shift that burden back on to the state. Perhaps the most acute sign of the desperate situation most Japanese firms face is the government’s decision, at the behest of several large heavy industry companies, to introduce defined contribution plans to the market place.
From this crisis comes opportunity, especially for domestic and foreign asset management organizations. Government regulators and corporate plan sponsors, desperate to overcome pension under-funding, are creating an environment in which fund managers can receive larger and pricier portfolio investment mandates. As this explains, deregulation and reallocation of the retirement fund marketplace have helped spark growth in the Japanese asset management industry. But several hurdles remain, and many of them are cultural.
Thomas Marsh is with Boston-based Cerulli Associates. This article is based on their report, “Trends in the Japanese Asset Management Marketplace”. For information see