Priorities for the Japanese Economy in 2017 (January 2017)

Blind Corner of Public Pension System Reform: What is needed for the evolution of reform debate?

OGURO Kazumasa
Consulting Fellow, RIETI

Against the backdrop of a rapidly aging population and persistently low fertility, the cost of social security continues to soar in Japan, and running a huge fiscal deficit year after year has now become the norm. The result is mounting government debt that exceeds 200% of the nation's gross domestic product (GDP). A principle of economics states, "There is no such thing as a free lunch." As explained in detail in my recently published book (Note 1), even if the Bank of Japan (BOJ) purchases all of the government bonds, it would not eliminate the burden on the Japanese taxpayers. From the viewpoint of economics, besides the aforementioned explicit debt, the Japanese government has implicit debt in the form of social security. For instance, the government owes implicit debt in the form of public pension obligations of an amount equal to about 150% of GDP.

Regarding implicit debt, I discussed in detail in my article published on the RIETI website some years ago. Here, I would like to simply note that the term is defined as the difference between the amount that should have been funded if the public pension program were a funded system and the actual amount funded.

To begin with, under Japan's public pension system, the government incurs liability to pay benefits in the future, i.e., benefit obligations, as people make contributions to the program. The "amount that should have been funded if the public pension program were a funded system" referred to above corresponds to accumulated benefit obligation (ABO), which represents the sum of benefits currently paid out and the present value of future benefit obligations accrued to date.

The difference between this amount and the actual amount funded is equal to about 150% of GDP. In a bid to reduce such implicit debt and enhance the financial sustainability of the public pension system, the government introduced an automatic benefit adjustment mechanism called a "macroeconomic slide" in 2004. However, the system has been invoked just once in FY2015. In the extraordinary Diet session in fall 2016, the ruling and opposition parties clashed over a government-sponsored pension system reform bill, which calls for, among other things, reinforcing the macroeconomic slide system effective from FY2018.

Key points and three perspectives of the proposed pension reform: Budgetary separation and generational accounting are also essential

The proposed pension reform will make two significant changes. The first change concerns the "price and wage slide" system, another benefit adjustment mechanism to address short-term changes in prices and wages. Under the current rules, in the case where both prices and nominal wages are on a decline with the latter falling more sharply than the former, benefits are reduced only by the rate of decrease in prices. Meanwhile, in the case where prices are on a rise, no adjustments are made to benefits even if wages are falling. Under the new rules, benefits will be reduced by the rate of decrease in wages in both of the above cases. In other words, the benefit adjustment mechanism will be redesigned from a generous one to a conservative one.

The other significant change concerns the macroeconomic slide system, which is designed to address long-term structural changes such as a decrease in the working population relative to the elderly population. Under revised rules, any reduction to benefits that should have been but could not be made in a certain year due to low or negative growth in prices and wages will be carried over to be implemented in the following year or beyond within the limits that the combined rate of decrease in benefits (i.e., carryover and new adjustments) does not exceed the rate of increase in prices and wages.

Japan's overall wage growth was negative in seven out of the 12 years since the 2004 pension system reform. Against this backdrop, the Democratic Party, the leading opposition force, denounced the pension system reform bill, calling it a "pension-cutting bill." On the other hand, the ruling block maintained that the proposed reform is essential to ensuring the intergenerational equity and sustainability of the public pension system.

Although both sides had some truth in their arguments and reasoning, some important perspectives were lacking in their debate and the media coverage thereof. Reforming the pension system requires considering the following three aspects simultaneously: (1) financial sustainability of the pension system, (2) degree by which the intergenerational inequality is corrected, and (3) intra-generational redistribution.

As far as what can be judged from the relevant media reports, the debate between the ruling and opposition parties was primarily focused on the first perspective, although the second perspective was touched upon to some extent. In reality, it is highly questionable whether the fiscal sustainability of the pension system is truly ensured. However, arguments made by legislators from both sides were premised on a steady inflow of funds from the national treasury to help finance the cost of pension benefits. They seem to assume that sufficient financial resources can be secured without raising taxes or reducing expenditures. It is as if money were falling from the sky. Such premise is unrealistic and absurdly optimistic. The truth is that funds transferred from the national treasury are financed either by tax revenue or proceeds from issuance of government bonds. That is, a significant portion of pension benefits are financed by fiscal deficits.

Worse still, the amount of social security benefits expenditures increased by some 26 trillion yen over the 10 years between FY2006 and FY2015, i.e., at the pace of some 2.6 trillion yen per year (equivalent to revenue from a 1% consumption tax rate). Even if the consumption tax rate is raised to 10% in October 2019, there is a high possibility that Japan's fiscal situation will fall into a critical condition in the not too distant future unless drastic fiscal and social security reform is carried out. In order to prevent this dreadful scenario from turning into reality, we must, first and foremost, separate the social security budget from the general account budget, as pointed out in my previous article.

Now, what about the second perspective, i.e., intergenerational inequality? Intergenerational income distribution programs are basically a zero-sum game. Thus, reducing pension benefits payable to today's elderly people will alleviate the burden on today's young and future generations. However, the proposed pension system reform will do little to address the inequality that exists between generations. The reason is quite simple. Even if the macroeconomic slide system is invoked to lower the level of benefits paid to today's elderly people, it will also reduce the amount of benefits payable to today's young and future generations in real term while the burden on those generations, imposed in the form of contributions to the public pension program or else, will increase so as to secure sufficient funds for future pension payouts.

As a way to enable us to measure the degree by which the intergenerational inequality is corrected, it is necessary to estimate and disclose the lifetime net effects of the public pension system on different generations by using the generational accounting method. In order to resolve the inequality fundamentally, it is also necessary raise the pensionable age (for instance to 70) and shift from the current pay-as-you-go system to a funded system (Note 2).

Exploring the possibility of introducing a minimum guarantee and claw-backs

There were no in-depth discussions on the third perspective, i.e., intergenerational redistribution. As debated in the latest Diet session, the pension replacement rate usually refers to the level of pension benefits as a ratio to the average income of working men. However, when the term is used in the context of the public pension system of Japan, it refers to the pension replacement rate applicable to the model household, a married couple in which the husband has been a salaried worker and the wife has been a full-time homemaker for the past 40 years. The amount of pension benefits paid to the model household in FY2014 totaled some 2.6 million yen (218,000 yen per month), with the husband receiving some 1.8 million yen (154,000 yen per month) and the wife some 770,000 yen (64,000 yen per month).

However, the amount of pension benefits paid to the model household deviates significantly from the average household observed in the actual distribution of pension income. We can see it by drawing a chart illustrating the percentage of men and women falling into each pension income range, using data from the Ministry of Health, Labour and Welfare's Comprehensive Survey of Living Conditions of Pensioners 2012. For instance, 19.8% of men received pension income of two million yen to 2.5 million yen per year, roughly comparable to the amount received by the model household. However, as many as 55% of men received less than two million yen (40.4% received less than 1.5 million yen). The reason for this is that those who receive only the basic benefits under the National Pension Program, such as self-employed people, are included in the distribution of pension income. Thus, debating pension system reform based solely on the replacement rate for the model household may lead to a wrong decision.

The results of the latest actuarial valuation of public pension finances made in 2014 show that the replacement rate for the model household would drop from 62.7% in FY2014 to around 50% in FY2043 even under optimistic scenarios that assumes relatively high economic growth, meaning that the amount of pension benefits receivable 30 years later would be about 20% lower than the current level. Focusing solely on the replacement rate for the model household, instead of basing the discussion on the true-to-reality distribution of pension income, poses the risk of underestimating the problem of growing poverty among the elderly who are eligible to receive only a small amount of pension benefits.

One reason behind a rapid increase in the number of elderly people in poverty is in the design of the macroeconomic slide system that would reduce pension benefits not only in the earnings-related portion but also in the basic portion. In order to avoid this, it is necessary to create a system to provide a guaranteed minimum pension applicable to all. And as a way to secure sufficient finance for this, we should introduce a claw-back system under which the amount of basic pension benefits would be reduced for those pensioners whose income exceed a certain level.

The next actuarial review of public pension finances is slated for 2019, and it is hoped that the debate on public pension system reform will evolve further in a meaningful direction by that time, incorporating the above-discussed perspectives.

December 28, 2016
  1. ^ Oguro, Kazumasa (2016), Yokin Fusa ni Sonaeyo! [Be Prepared for the Freezing of Bank Accounts!], Asahi Shimbun Publications Inc. (in Japanese)
  2. ^ For further details, see Oguro, K. (2014), Zaisei Kiki no Shinso [Underneath the Fiscal Crisis], NHK Publishing, Inc. (in Japanese)

December 28, 2016