Issues Facing the Japanese Economy in 2013 (January 2013)

Pension Reform: Possible and impossible

Consulting Fellow, RIETI

The coalition government, formed by the Liberal Democratic Party (LDP) and the New Komeito Party, will carry out more in-depth discussions on the reform of the social security system, while having the newly-established Headquarters for Japan's Economic Revitalization and the National Council on Social Security System Reform, which was formed on the basis of the agreement among the LDP, New Komeito, and the Democratic Party of Japan (DPJ), liaise with each other. This column discusses the issues that are of the highest importance in the public pension system reform to be implemented.

Advantages and disadvantages of the new public pension system reform plan formulated by the DPJ

During the three years and three months of the DPJ government, it is no stretch to say that discussions on the public pension system reform remained stagnant. One of the reasons was that the government got stuck too resolutely to the idea of making a transition to a new pension system proposed by the DPJ. Its idea of the new system—in which all of the subscribers are enrolled in a unified earnings-related pension system and people with low pensions will receive the guaranteed minimum amount— was an ultimately perfect plan, if ever completed, and it was one of the major campaign pledges of the party. However, realizing it was extremely difficult, as was expected from the beginning, with so many specialists questioning its feasibility.

The reason for the difficulty was, in short, that this proposed scheme completely ignored the question of continuity from the present scheme. Reform of the social security system must be planned on the basis of discussions taking into consideration of the present system and resources. The DPJ's pension scheme was almost like repairing an airplane while in the middle of flight. It is impossible to replace the engines in the air, even if they are found to be problematic. The public pension system, which is a kind of long-term insurance, is strongly subjected to this restriction (It is difficult for the government to change ex-post facto rules on the future benefit formula, which is based on previous premium payments). It was self-evident that a planned scheme ignoring this factor could never be materialized.

Nevertheless, prior to starting discussions on any kind of reform plan, one should reevaluate the reason for the DPJ's pension scheme receiving so much public support. The DPJ's pension scheme can be summarized by the following two factors. First, regardless of work history before retirement, there is no difference in the pension benefit. Second, the pension scheme exercises sufficient income redistribution function within itself. In other words, these two factors are the weak points that the present system has failed to achieve. In the present system, self-employed workers and non-regular employees can only receive national pension (basic pension) benefits, while regular employees can subscribe to the employees' pension (welfare pension). In addition, it has been made clear that the basic pension benefits would decrease gradually in the future. A pension system is meant to secure future livelihoods, and many people want it to overcome such intrinsic shortcomings, which was a likely reason that led to their entrusting of power to the DPJ.

What can be changed and how?

It is yet to be seen how deep the discussions on reform by the National Council on Social Security System Reform can dig into the framework of the system, but in any case, it is absolutely imperative to reform the above-mentioned shortcomings of the present system in order to recover the people's trust in the public pension system. Nonetheless, as previously mentioned, pension system reform must be implemented as an extension of the current system. So, how can this be done?

The most important key to pension system reform in this direction is to separate completely the financial resources of the basic pension (first-tier) and that of the earnings-related pension funds (second tier of the employees' pension and mutual pension). In concrete terms, the social insurance premium for the basic pension for all subscribers, including category-3 insured persons, should be made by fixed-amount payments (to name it "basic pension premium"), with the possibility of reduced rates and exemptions, and separated from the fixed-rate premium payments for the second tier of the employees' pension, thus separating these financial resources completely (Note 1).

By completely separating the financial resources of the basic pension and that of the second tier, both employees' pension and mutual pension can be transformed into completely earnings-related pensions. This will have the following advantages. The current pension premium payment structure needs to set the lower limit on premium payments in employees' pension due to consideration for impartiality when compared to the national pension, but this can be almost completely eliminated. It means that the welfare pension can be extended to include all non-regular employees, such as part-time employees. In this way, the pension system can be improved in the direction of the DPJ's pension scheme, which has the advantage of no differences in pension benefits regardless of work history.

However, it is extremely difficult to extend the second tier pension to include self-employed workers. Employers are also making payments into the employees' pension, and this creates the feeling of unfairness in contribution when compared to subscribers of the national pension (Note 2). This is known as the issue of imputation and incidence in the social insurance premium. Economists and social security theory specialists are clearly divided in their opinions on this issue, and it seems difficult to find common ground. Nevertheless, this will not cause serious problems because there is little necessity to grant earnings-related pensions, starting at a certain age, to purely self-employed workers who own assets and have no mandatory retirement age and can own assets. The more important issue is the advantages of reducing the gap between non-regular employees and regular employees in social security and correcting distortions in the market.

Regarding the issue of imputation and incidence in contribution by employers, some people will point out the divergence from the conventional pension system because subscribers to the welfare pension fully bear the fixed-amount payments of premiums in the basic pension system. This problem can be solved in the following way. In the current system, state contribution into the basic pension is half of the "benefits." My idea is to change this to half of the "contribution" of the basic pension premiums. In my trial forecast, calculated on the basis of basic pension benefits assumed in the fiscal review conducted in 2009, balancing the budget for the basic pension system can be achievable with a basic pension premium (self-pay only) of 14,893 yen (Note 3).

Why is this kind of reform urgent?

Why is a system reform that can reinforce income redistribution to some extent and extend the earnings-related pension system to non-regular employees necessary? In order to find the answer to this question, one needs to examine the future benefits level expected in the present pension system. The table below shows future benefits calculated by using the pension financing estimation program of the Ministry of Health, Labour, and Welfare on the premise of population estimates announced in the spring of 2012. Financial review conducted in 2009 under the LDP and New Komeito coalition government concluded that the replacement ratio of 50% can be maintained on the basis of long-term nominal investment yield at 4.1% and nominal wage growth rate at 2.5%, but the review was also based on an assumption, which is incredibly optimistic when considering the current situation, that the rate of national pension premium payments will have recovered to 80%. On the other hand, the forecasts shown in the below table is based on an assumption that the rate of national pension premium payments will stay at around the actual figure (59.3%) recorded in fiscal year 2010.

As the table shows, it is obvious that we have to be prepared to see pension benefits decrease substantially, and especially those from the basic pension will diminish significantly compared to those from the welfare pension, which is earnings related. In other words, while the current benefits from the national pension (approximately 65,000 yen in the case of full amount) already tend to be insufficient to support life after retirement, the benefits in the future are expected to fall below this level (to approximately 47,000 yen based on the present price level). In order to avoid such circumstance, the pension system must be reformed in a way that, if there are even the slightest earnings gained as workers, it must be reflected in the pension benefits. If it is not reformed in this way, it is very possible that the great majority of non-regular employees will become recipient households of public livelihood assistance.

If the pension system is reformed in the way explained thus far, this kind of catastrophic circumstance can be avoided to a certain extent. Moreover, this reform plan is relatively moderate and is achievable without drastically changing the present system. Therefore, I strongly hope that the new government will consider this type of reform plan which can effectively correct the shortcomings of the current pension system.

Table: Benefits from public pensions in the future in the form of replacement ratio
(ratio of benefits and average income of active workers)
Highslide JS
[ Click to enlarge ]
January 7, 2013
  1. ^ There are other important issues indeed, such as raising the pension eligibility age and improving macroeconomic slide mechanism, but I will discuss these issues in other papers.
  2. ^ In addition, if simply extending the earnings-related pension to include self-employed workers, it will cause another problem of significantly increasing the funds needed for benefit payments in the future.
  3. ^ Incidentally, in the current national pension, the premium is scheduled to increase in stages to 16,900 yen. If maintaining the basic pension benefits at around the present level, the basic pension premium needs to be set at around 17,755 yen. In addition, state contribution in this case does not need to be "half" of the contribution. For example, if the state contribution is 70%, a premium of 10,658 yen will be sufficient to maintain the benefits at around the current level.

February 6, 2013

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