International Perspectives on Japan's Pension Reform

The 2004 reform of Japan's pension system presents a paradox in that most of the Japanese public is still skeptical of the pension system's sustainability, while economists abroad and major international organizations such as the World Bank have given the reform high marks. The significant difference in assessing the 2004 reform may be attributed to the fact that the basic principles of the public pension system have become blurred and increasingly difficult to understand. At the RIETI policy symposium "Japan's Pension System -Evaluating the 2004 Reform and Establishing Clear Principles for Further Reforms-" on December 15-16, RIETI will present the interim research results of its social security projects including the analysis based on a newly developed simulation model (RIETI Model) and bring together a broad panel of Japanese and overseas economists. The purpose of this symposium is to jointly evaluate the 2004 reform by clarifying the basic principles and provide insight into the directions of future reforms. In advance of the symposium, RIETI Report interviewed Dr. Olivia Mitchell, Professor of Insurance and Risk Management at The Wharton School of the University of Pennsylvania, and Mr. Ole Settergren, Director of the Department of Pensions of Sweden's Social Insurance Agency.

Olivia Mitchell is Professor of Insurance and Risk Management at The Wharton School of the University of Pennsylvania. She is also Executive Director, Pension Research Council; Director, Boettner Center on Pensions and Retirement Research, and holds research positions at several other institutes. Previously she served on the U.S. Department of Labor's ERISA Advisory Council and the National Academy of Social Insurance's Board of Directors. She specializes in the economics of public and private pensions, international private and social insurance, health/retirement analysis and policy, and labor economics and public finance. Dr. Mitchell has won numerous awards for her research efforts including the TIAA-CREF/Paul A. Samuelson Award for Outstanding Scholarly Writing on Lifelong Financial Security in 1999. She received her Ph.D. in Economics from the University of Wisconsin-Madison. Her recent major works include "Reinventing the Retirement Paradigm," Oxford University Press, Oxford, UK, 2005 (co-edited with Robert L. Clark) and "Pension Design and Structure: New Lessons from Behavioral Finance," Oxford University Press, Oxford, UK, 2004 (co-edited with Stephen P. Utkus). An excerpt of the interview is below. To read the full interview, go to:
http://www.rieti.go.jp/en/special/policy-update/023.html

RIETI Report: You have provided consulting on the pension system to the Cabinet Office of the Japanese government since 2001. Could you evaluate the 2004 Japan pension reform in terms of transparency and inter-generational equity?

Mitchell: The current Japanese approach to retirement security has roots in the past, traced to the military pension established in 1875 and the employee-side counterpart set up in 1942. Yet as in all developed nations, the Japanese retirement system has been adjusted and changed over the years many, many times. These reforms have included expanded coverage; changes in benefit levels; increases in retirement contributions; alterations in retirement ages; increasing reliance on general revenue financing while at the same time building up a reserve fund; and recently, the use of a "negative adjustment" formula (the so-called 'macroeconomic' automatic stabilizers) to reduce benefits when demographic factors move adversely. The result is, perhaps inevitably, a very complex and poorly understood system which is far from transparent.

Of course the pay-as-you-go retirement systems in most developed nations have all been in continual flux since they were established, making it inherently difficult to explain to new generations of workers and retirees exactly how "their" system works. The reality is that each cohort in effect faces a "different" set of tax and benefit rules, both ex ante (when they join the workforce) and ex post (after retirement). Reformers who appreciate this fact and truly seek to make their retirement schemes transparent would therefore do well to design simple systems where the rules admit adjustment to shocks but where the rules themselves need not be continually debated in the political arena. Few countries have been able to maintain a high degree of commitment to a long-term stable retirement system, feeling that other goals must be balanced against the needs of preserving any given promised set of retirement system contributions and benefits. In this sense, the Japanese reform of 2004 with its demographic-based benefit adjustment formula is a step in the right direction. Yet wise analysts project that this adjustment formula is incomplete, as it integrates only the numbers of participants and life expectancy, but not macroeconomic uncertainty (e.g. changes in wage growth and the taxable wage base, capital market returns, inflation, etc). And continued uncertainty in the old-age arena leads some of today's workers to express reasonable skepticism about whether the old-age system will "be there" for them. Hence the tendency to avoid contributing to the system, which simply exacerbates solvency concerns.

Whether Japan's reforms will improve equity is unclear without a more detailed definition of which of several equity concepts are of most interest. For instance, in the case of the U.S., the Office of the Actuary has computed lifetime expected net benefits for cohorts; these naturally are not representative of the expected results for any specific type of individual or household. In order to understand within cohort-equity results, microeconomic or individual record-panel data are required to do microeconomic simulation models which embed heterogeneity. It is also important to decide whether one is interested in ex ante or ex post net benefits (benefits minus taxes), since (a) anyone who does not survive to retirement will not receive benefits, and (b) the system rules in place during one's retirement are usually quite different from what was promised during one's work-life. In carrying out such equity computations, it is also key to compute net benefits after adjusting for system insolvency -- that is, correcting for all of the system's possible shortfalls and specifying methods to finance them. Thus computations of cohort-specific "rates of return" must identify exactly how system shortfalls are to be handled inclusive of general revenues or financing from other sources, how any accumulated pension assets will be spent, and how uncertainty will be allocated across and within cohorts. In order to enrich the equity discussion, it will be essential to develop individual and household panel data which researchers can then use to begin to address the diversity of the Japanese labor market and retirement experience.
<full text of interview at http://www.rieti.go.jp/en/special/policy-update/023.html>
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Ole Settergren is Director of the Department of Pensions of Sweden's Social Insurance Agency¹. In his previous capacity a pension expert with Sweden's Ministry of Health and Social Affairs, Mr. Settergren was responsible for developing the automatic balance mechanism at the heart of Sweden's mid-1990s pension reforms that created the first automatically financially balanced pay-as-you-go (PAYG) pension scheme in the world. Prior to his roles in the Swedish government, Mr. Settergren worked in the private sector as a financial controller, underwriter, and financial advisor. He holds an MBA from the Stockholm School of Economics. An excerpt of the interview is below. To read the full interview, go to: http://www.rieti.go.jp/en/special/policy-update/023_2.html

RIETI Report: Sweden's pension system (the inkomstpension) is quite attractive in that it is pay-as-you-go and allows the individual to track his/her balance like a savings account. The system's maintenance also requires strong social governance. How were the 1990s Swedish pension reforms presented/"sold" to the public initially and how were they received?

Settergren: I share the judgment that one of the attractions of the inkomstpension is that it can be presented like a savings account and that it requires a strong social governance to be maintained.

You would probably get different answers to the question of how the reform initially was presented to the public depending on who you ask. This is, naturally, my version.

From the pension reformers' point of view the basic argument for the reform was one of financial sustainability. The reform implied a change from a pension scheme that in normal to pessimistic assumptions was judged to be going bankrupt, to a pension scheme that regardless of economic or demographic assumptions would be financially sustainable. This was the number one selling point.

However it was of course obvious that this change would imply lower pensions in normal to pessimistic scenarios -- this was the negative side of the "sustainability argument." This presented pension reformers with perhaps their most difficult task, convincing enough people that still the change should be made.

In this context one must admit that Swedish politicians and perhaps also their experts had a relatively enviable situation when compared with other countries that need to reform their pension schemes. The Swedish demographic projections are not as troublesome as those of many other countries. This is due to slightly higher experienced and projected fertility rates, roughly 1.8, than many other OECD countries and high experienced and projected immigration². Contributing to the relatively easier situation in Sweden was also the large buffer fund of the old pay-as-you-go pension scheme which increased the financial and political space for maneuvering the reform³. In this last respect -- a large buffer fund -- Japan and Sweden have a similarity. Thirdly, Swedish politicians gave themselves an advantage as they started relatively early with their grand reform.

The less tough than average demographic projections, the better than average financing of the old pension scheme, and the relatively early start gave reformers an opportunity, a selling argument that most other legislators do not have.

Swedish reformers could rightfully claim that the new scheme would on average give the same pension benefits as the old pension scheme would have given under reasonably good conditions: an average work life of 40 years, a real growth of 2% and a life expectancy that corresponded with the one measured in 1992. This I believe has been very important, and it is an argument that most other countries cannot rightfully claim.
<full text of interview at http://www.rieti.go.jp/en/special/policy-update/023_2.html

Notes:

1. Previously The Swedish National Social Insurance Board, which changed its name as of January 2005 when it merged with the 21 regional insurance offices.
2. In the projections immigrants are, with some delay, assumed to have similar labor force participation as others in the Swedish population. At present this seems not to be the case as the immigrant population, even after many years in Sweden has a significantly lower labor force participation.
3. The fund is at present some 25% of the Swedish GDP or four times annual pension payments. The fund was larger before the reform but the increased government payments to the pension system were balanced by "one-time" transfers that still have not been permanently settled.

The program for the RIETI Policy Symposium "Japan's Pension System -Evaluating the 2004 Reform and Establishing Clear Principles for Further Reforms-" is available at:

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