I have just returned from a very interesting trip to Japan. I was invited to give a series of lectures on enterprise risk management at the University of Kyoto, and to talk to members of the Institute of Actuaries of Japan in Tokyo about the way in which this subject is taught in the UK. However, whilst talking to Japanese actuaries, I discovered some interesting facts about their pension system.
Japan, has a large – though declining – number of defined benefit pension schemes. It also has the longest-lived population in the world, with a life expectancy of 82.5 years even if there is no future improvement in mortality rates. Furthermore, it has very low interest rates, with the 10-year yield being below 1.5 per cent. This combination would seem to suggest that Japanese pension schemes – and their sponsors – have a major problem. However, the problem is not as serious as one might think. From 2002, many pension schemes have been converting to new Defined Benefit Corporate Pensions. These frequently offer annuities payable only for a fixed term, usually 10 to 15 years from retirement. As a result, increasing levels of longevity have a decreasing impact on the cost of pension provision.
The limited term of pensions also means that they have a smaller duration, so their values are less sensitive to changes in interest rates. The fact that the pensions are usually level reduces the duration and interest rate sensitivity still further.Interest rate sensitivity should in fact not be too great a concern in Japan. The main risk that pension schemes are exposed to in this regard is that interest rates will fall, increasing the value of pensions. However, when interest rates are as low as they are in Japan, the scope for further falls is limited. This is particularly true when there is an upward sloping yield curve, so rates are higher for longer terms, and the liabilities are in the short to medium term. I was therefore surprised to hear that liability driven investment (LDI) is gaining traction in Japan. The main focus of LDI is to reduce interest rate risk for pension schemes – but where is the risk when there is so little scope for interest rates to fall?
Of course, there are still issues faced by these pension schemes and their members. Investment performance has been poor, and this has reduced the solvency of many schemes. Furthermore, individuals receiving fixed-term annuities need to ensure that they have enough money put away for when their pensions cease. However, it is interesting to see that in a country where longevity is so widespread, defined benefit pensions continue to exist.