Learning lessons from Japanese pension funds

Daisuke Ishihara explains how Japanese pension funds coped in the era of deflation and what European pension funds can learn as a result

Recent news will do little to boost Japanese pension schemes, with business confidence levels displaying their greatest decline in the last thirty years. However, Japan has been here before and is well equipped to ride out the potential storm ahead. European pension funds would do well to heed the lessons learned during Japan’s ‘lost decade’ as predictions of economic downturn in Europe currently prevail. Europe shares similar demographic characteristics to Japan, and just as Japan has done, some tough decisions are going to have to be made in the coming years.

The nature of the dire economic numbers coming from Japan indicate that the country could return to the deflationary conditions it experienced in its “lost decade”. At that time, deflation and falling stock values caused a rise in real pension costs, which worsened an already difficult situation.

Initially Japanese pension plans were at a loss as to how to deal with the extreme difficulties that deflation was causing them. In time though, new policies and approaches were activated and a new understanding of what was possible was developed and communicated to members of pension plans.

For a country where the overall population is ageing rapidly and the burden on the corporations paying their pensions increasing, the trustees of Japanese pension funds seem relatively calm about the prospect of more deflation. As a reference point to the reader, in March 2009, over 95% of the pension fund universe in Japan were of the Defined Benefit (DB) type pension scheme. The contribution levels of this kind of scheme are directly influenced by the state of the equity markets.
Japanese pension funds, known as “Employees’ pension funds” in Japan, have become the most experienced pension funds of the DB type at dealing with long deflationary slumps.

In March 2003, three years after the bursting of the technology bubble, Japanese pension funds had experienced three years of negative equity market returns (annual falls of -9.83%,-4.16%,-12.46% according to Pension Fund Association). This followed on from a massive fall in market values in the early to mid-1990s. In 2003, we believe that two thirds of Japanese pension funds were underfunded, and some by large amounts. Today, we assume the number of underfunded pension funds is closer to 90%, and yet to an outsider, their trustees appear remarkably sanguine about the situation. Why should this be?

First of all, the Japanese government is being proactive in dealing with their difficulties. For example, it is expected to further reduce funding level requirements for corporate pension funds, allowing them to temporarily reduce contributions. This is a helpful measure if a temporary period of deflation is expected. Secondly, the Japanese government and pension funds have recognised that markets are inevitably cyclical. The Japanese economy will be weaker at times and in recession, equity markets will be weak and more pension funds underfunded.

Similarly, there will be periods of stronger economic conditions and rising equity markets when pension funds will tend to be well funded. In short, pension fund surpluses and deficits should be managed across a full cycle, and government needs to take account of this in policy setting. As a comparison, while 70% of pension funds were in deficit in 2003, over 90% were in deficit in 2001, and only 20% in 1999. Lastly, pension funds in Japan have already set up their portfolios to function within a deflationary environment, and so trustees feel prepared to deal with this circumstance.
During the last economic downturn, pension funds tackled their problems by cutting their members’ benefit levels. Annuity levels were reduced as were lump sum payments.

Pension funds also reduced risk levels within their portfolios. According to the Pension Fund Association, between March 2000 and March 2008, average domestic equity holdings fell from 36.5% to 26.9%. The aim was a reduction in portfolio volatility. As this also has the potential to reduce long term returns, less volatile assets with reasonable upside potential were also sought. For example, holdings in international fixed income rose from 7.4% to 12.5% and average investment in hedge funds rose to almost 6%.

Government also played its role by loosening some of the requirements on pension funds. Funding level criteria were reduced and plans were given more flexibility in assessing how they evaluated their assets and liabilities. Retirement ages were also increased. This increased flexibility and reduction in payouts is not really in members’ interests, but it is a pragmatic response to the difficulties that Japanese pension funds have been facing. Recent articles written on the subject have predicted criteria changes that could possibly be published by the government soon. According to these articles, this would include changing funding level criteria and liability evaluation methods which we believe will help both pension funds and sponsors. In terms of required funding level, it is expected that the Government will reduce it to 85% or less.

As for the methodology for evaluating pension liabilities, it is expected to be eased significantly. This reflects the difficult environ-ment for investment management performance over the last fiscal year.

Japanese pension funds have been faced with a difficult situation. When one looks at it, the responses to a deflationary environment, a weak economy and negative economic trends have been addressed in a number of ways. Overall, Japanese pension funds have been given more flexibility by the government. They have reduced the risk levels within their portfolios and have reduced their overall payouts to plan members. They still have a fiduciary duty to their scheme members, and aim to remain in surplus for at least a good part of the investment cycle. Their job is therefore still a difficult one so, while a period of deflation holds less fear for them than say ten years ago, it is not something to be welcomed.

However, by a combination of the measures discussed above, with a government sympathetic to their problems, they are possibly in a better position than their western counterparts. What these latter also lack is a society which is more compliant and able to accept and understand the necessity for such changes. Yet it is not to say that it was easy for pension funds to face the sheer level of deflation experienced. The sheer change in the types of pension plan in Japan is a very clear indicator of this. The number of ‘Employees’ Pension Funds’ has changed from 1,800 a decade ago, to the present level of 600. A total of 800 schemes have changed their pension plan to one less reliant on volatile equities to achieve their objectives, and the remaining 400 have been dissolved.

In our opinion, we truly think that Japan is well equipped to ride out the potential storm ahead as it has been here before and the lessons have been learnt. European pension funds will have to make these changes in the future, so they would do well to heed the lessons learned during Japan’s ‘lost decade’ as predictions of economic downturn in Europe prevail mixed with an ageing population. They represent difficult decisions which will cause controversy, especially with Europe’s strong trade unions but Japan has shown that they can be implemented through government will and a population which has been well educated in the problems faced by their pension system.

Written by Daisuke Ishihara, Executive Director, Chuo Mitsui Trust International