Global Aging Issues
Pension Issues in Japan
A Conversation with Noriyuki Takayama / Event
February 2006
AARP Global Aging Program Idea Exchange Series
Washington, D.C.
Noriyuki Takayama, professor of economics at Hitotsubashi University, discussed Japanese pension issues at AARP’s Global Aging Program Idea Exchange held Monday, September 12. His presentation outlined pension provisions in Japan before its 2004 reform, implications of the 2004 reform, pension challenges that still remain, and future policy options. Takayama summarized lessons learned from the Japanese pension experience at the end of his presentation, encouraging the audience to apply these findings to the U.S. social security debate.
Pension Provisions before the 2004 Reform
The public pension system in Japan is two-tiered. First, a basic flat rate provides pensioners with 66,200 yen (approximately U.S. $600) monthly. Second, an earnings-related benefit provides pensioners 28.5 percent of their career average income in real earnings. The replacement rate for a one earner couple is 60 percent of their net earnings, roughly 223,000 yen (or U.S. $2,100). Pension benefits are CPI indexed. The normal age at which individuals receive pensions is 65 years old.
The Japanese pension system is primarily pay-as-you-go with partial prefunding. The pension system is funded by employee contributions and government subsidies. Employees (and their employers combined) contribute 13.58 percent of their annual wages. Government subsidies pay for approximately one-third of basic flat rate benefits.
The aggregate amount of social security pension benefits is currently 44 trillion yen (approximately U.S. $400 billion). This sum amounts to 9 percent of the Japanese GDP, an even larger percentage than domestic output of the automobile industry, and the figure is rapidly increasing.
Demography
The Japanese population is expected to decrease to one half of its current size in the next 100 years, as a result of a growing aging population and decreasing fertility rates. This year, 20 percent of their total population is above the age of 65. This figure will increase by more than 30 percent in the next thirty years.
Japan’s Primary Pension Challenge
The balance sheet of social security pensions in Japan describes the current financial status in stock terms by presenting assets and liabilities with their compositions. Even if the income statement of the social security pension system enjoys a surplus, the balance sheet often suffers from huge liabilities.
The Japanese balance sheet has two parts: assets and liabilities accrued from contributions made in the past (part one) and assets and liabilities accrued from future contributions (part two). Although the funding sources of the current provisions will almost be sufficient for future benefits, large excess liabilities have accrued from part one. These excess liabilities amount to 500 trillion yen, equivalent to 100 percent of the GDP. This deficit is the result of promises made to early beneficiaries before adequate funding sources were arranged.
Under the pay-as-you-go system, early beneficiaries profit, while younger actively working generations and future generations make large contributions to cover the legacy debt while reaping less benefits.
Takayama points out that the Japanese pension system acts as a redistribution mechanism, making the elderly better off than individuals age 30 to 44. He also argues that pension benefits are still too generous and should be reduced. Currently, social security benefits comprise 78 percent of retirement income of Japanese elderly.
The 2004 Reform
The 2004 reform law attempts to reduce the legacy debt and adjust benefits according to annual contributions to avoid future deficits. There are three components to the bill.
- First, contributions were increased by .354 percentage points every year until 2017, at which point they will remain at 18.30 percent of income.
- Second, subsidies from the general revenue were increased. Under the reform, government subsidies increased to cover one half of the flat-rate basic benefit, compared to the one third previously covered.
- Third, benefits are adjusted to reflect demographic factors. The new indexation formula will operate as a virtual automatic balance mechanism. The formula used to account for demographic factors considers the declining number of contributors and the increasing average life expectancy at age 65.
The combined changes in demographic factors are expected to reduce benefits by .9 percent for the next 20 years. To illustrate better, a typical couple receiving social security benefits in 2004 that amount to 60 percent of their retirement income will find those benefits reduced to 43 percent by 2023.
In summary, the objective of the reform bill is to reduce the excess liabilities of the legacy debt by generating a surplus from increased contributions and reduced benefits. These policy measures are expected to generate excess assets of 420 trillion yen, which will offset the excess liabilities of the legacy debt.
After the 2004 Reform: Remaining Difficulties and Policy Options
Increased contributions and benefit reductions will result in future generations receiving pensions worth less than their contributions, which raises intergenerational equity issues. The present value of future benefits is expected to amount to only 80 percent of the present value of future contributions of the younger generation.
Takayama raised the question: Shouldn’t baby boomers and current pensioners who benefited most from past promises carry the greatest burden of the legacy debt rather than future generations? Why would actively working generations participate in this system, since it isn’t incentive compatible for them?
- Handling the Legacy Debt: One alternative is to introduce an ear-marked consumption-based tax instead of increasing contributions. Components of this policy would include: reducing benefits and increasing transfers from the general revenue by imposing a consumption-based tax. Under this policy option, the legacy debt burden would be shared in proportion to capital income or consumption instead of in proportion to future earnings. Takayama notes that switching from a pay-as-you-go system to a funded one would not address the legacy debt problem.
- Re-building the Future System: The other option involves establishing a direct link between contributions and benefits by introducing a Swedish type of NDC, which would make the pension system incentive compatible for future generations and ensure that adequate income is provided in old age.
At the same time as public pension challenges have grown worse, private sector pensions have declined. The private sector pension system is called Kosei-Nenkin-Kikin (KNK), or employees’ pension fund. The plan has two components: an equivalent earnings-related portion and a supplementary benefit. Employees participating in the plan receive a payroll tax rebate of 3.2 to 5.0 percent. The set rate of return is 5.5 percent in nominal terms.
The number of KNKs was once steadily increasing, up to 1,833 in 1996, but recently there has been a sharp decline, bringing the total to 746 in August 2005. The participation rate, which was 40 percent at its peak, dropped to 18 percent in 2004. This drop is attributed to the radical relaxation of laws concerning KNK, allowing companies to re-contract in social security.
Many companies gave up offering KNK plans because the investments into which their contributions were funneled had performed so poorly that they failed to earn a rate of return adequate to cover benefits to employees. Takayama explained that investment performance in recent years had fallen below the nominal rate of 5.5 percent, resulting in an enormous build up of excess liabilities. The situation even negatively impacted the mother company’s rating in the capital market. In March 2005, a group of securities companies even dismissed their KNK plans, indicating that such plans were not promising at all even for experts of asset management.
Lessons Learned from the Japanese Experience
- Assignment Problem—The legacy debt is a sunk cost resulting from decisions made in the past. Takayama recommends separating the legacy pension problem from the problem of re-building the future system.
- Automatic Balance Mechanism—An automatic balance mechanism offers the ability to adapt to an ever-changing and unpredictable world. Takayama believes the mechanism should be more comprehensive in Japan, taking into account economic factors as well as demographic.
- Taste of Pie rather than Size or Distribution—Takayama cautions us to question whether social security pensions are worth buying. Are they incentive compatible?
- Balance Sheet Approach—Takayama recommends the balance sheet approach because it offers a way to evaluate the long-run financial sustainability of social security pensions and the financial impact of various reform alternatives.
- Opting Out vs. Adding On—In Takayama’s opinion, the opting-out plan in Japan is a failure.