Policy Update 023 Pre-event Interview No.1

Improving Transparency and Equity of Japanese Pension System

Professor of Insurance and Risk Management, The Wharton School, University of Pennsylvania

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 interviewed Dr. Olivia Mitchell about how to make the Japanese pension system more transparent and how to keep the system solvent in the face of demographic problems.

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).

RIETI: 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.

RIETI: With 28% of its population projected to be over 65 by 2025 (compared to 12% for the U.S.), Japan especially faces what you called an "aging population tsunami." Japan has different factors from the U.S. such as very limited immigration and a low fertility rate. How could Japan keep the system solvent under such distinct circumstances?

Mitchell: In carrying out these projections, I am convinced that policymakers must develop a more comprehensive framework of government budgets. This is essential to better understand and prepare for the unprecedented economic costs of population aging. In the case of the U.S., it has recently been estimated that the unfunded net liability of future old-age income payments totals about $11 trillion, whereas the retiree medical shortfall is about $60 trillion -- and this awe-inspiring figure excludes long-term care projections. I would very much like to learn more about the equivalent concepts in the Japanese case. While some argue that such assessments should not be carried out for government programs, the countervailing position, which I find more persuasive, is that "forewarned is forearmed," and greater transparency regarding the future economic impact of aging will be necessary in deciding what the most useful and economically viable options might be.

RIETI: In your book, Pension Design and Structure: New Lessons from Behavioral Finance (2004), you suggest that people strive to maximize their self-interests but they often fail to act in accordance with the expectations of rational economic and financial theory due to various reasons. What implication does this have on designing a public pension system?

Mitchell: The book discusses the key challenges that individuals face when they contemplate retirement saving, investing and decumulation. Those designing retirement systems should be aware that most people find saving to be particularly painful, since deferring consumption is not usually pleasurable (and can seem most unrewarding!). The book offers suggestions about how to help people "do what they know they should," such as having automatic enrollment, default investment choices and at least partial annuitization.

Interview conducted by Takako Kimura, online editor, on December 9, 2005.

December 9, 2005

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