From the July 2006 issue of Investment Advisor • Subscribe!

July 1, 2006

Behind the Numbers

Japan's Social Security overhaul can teach the U.S. a thing or two

Until recently, Japan's public pension system was in grave danger of being unable to serve the retirement needs of its people in years to come. But a series of measures introduced by the Japanese government in 2004 have managed to plug the gaping holes in a sinking ship and could, some experts say, even serve as a potential model for the U.S.

Undoubtedly, there are many differences between the U.S. and Japan, not least the structure of their social security systems. Japan's public social security consists of two-tiers: The National Pension Scheme (NP), a flat-rate scheme covering the whole population, and then an earnings-related tier consisting of the Employees Pension Insurance (EPI) for private sector employees, and the Mutual Aid Associations (MAA), for public sector employees.

Population demographics between the U.S. and Japan are also very different, but even so, the U.S. would be well-served by looking at what Japan has done, says Junichi Sakamoto, chief advisor to the pension management research group at the Nomura Research Institute in Tokyo. Social security in the U.S. will suffer in the coming years from the same financing problem that Japan has narrowly escaped if nothing is done to reestablish equilibrium in the system, and prevent the depletion of the social security trust fund.

The hallmark of the Japanese reform lies in fixing contribution schedules for the future years first and then determining the benefits that can be sustained by those contributions, subject to a floor below which the benefits should not fall.

This mechanism should, in theory, hold in check the rate of increase of pension benefits by taking into consideration both the shrinking labor force and the further extension of life expectancy. At the same time, the government will also increase its funding of the public pension program from the current 33% to 50% in 2009.

By fixing contributions at sustainable levels and reducing benefits within acceptable limits, Japan has ensured that the trust fund ratio for the EPI and other schemes will not fall below one until 2100, thereby reaching a state of equilibrium, Sakamoto says. By contrast, according to the 2006 Annual Report of the Board of Trustees of the U.S. Social Security Administration, the U.S. Trust Fund will be exhausted in 2040, if no measures are taken.

Proponents of the 2004 reform, like Sakamoto, are the first to point out inherent problems, not least the fact that benefit levels might become dangerously low. In addition, the modified indexation mechanism cannot be effective if wage increase is negligible, as is currently the case in Japan. However, wages are expected to increase this year, he says, and the government has also put in place a provision that calls for a "drastic review" of the system if benefits are projected to fall under a certain level.

Prior to the 2004 reforms, Japan took several other steps. In 2001, the government introduced measures to allow defined contribution plans, similar to the 401(k) model in the US, and, more importantly, reformed the Government Pension Investment Fund (GPIF), the largest public pension fund in the world with over $1 trillion in assets, into a separate entity that can invest in financial markets.

The GPIF's mandate is restricted mainly to Japanese bonds and equities, but people like Noboru Terada, the GPIF's former executive investment officer, are eager to push for a far broader menu of investment choices, including alternative asset classes like hedge funds. Investing assets in a range of financial markets, Terada argues, and making use of the skills and expertise of fund managers, will go a long way toward further shoring up the GPIF's funds.

The debate over whether to further liberalize the investment mandate of public funds is not likely to come to a conclusion anytime in the near future in the U.S. or Japan. Indeed, the 2004 reforms themselves are quite radical in that they put into question the very tenets of a social insurance system. In the coming years, Japan--like any other developed nation, including the U.S.--will have to keep working to find ways to not only maintain the liquidity of its social security system, but also to keep it tuned to the changes in both population demographics and the macroeconomic environment.

Savita Iyer is a freelance journalist who has long covered different aspects of the global financial services industry. She is based in Geneva, Switzerland, and can be reached at siyerwriter@yahoo.com.

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