Pension System in Japan

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Pension System
In recent years, the Japanese pension system has undergone various reforms in the public and occupational pension pillars. The current system consists of the flat-rate National Pension System and employment-related pensions for public and private sector employees; these two elements combined form the public pension pillar. Employers can establish Employee Pension Funds that operate as occupational pensions, but that substitute benefits from the earnings-related part of public pensions and can provide additional benefits. Moreover, employees whose employers do not provide occupational pensions and the self-employed can set up defined contribution accounts at the National Pension Fund Association. Defined benefit and defined contribution corporate pension plans were introduced in 2001. Voluntary private pension plans can take a variety of forms in Japan.

In 2004, public pensions were the subject of major reform. Automatic adjustment of benefit levels was introduced to allow the pension system to adapt flexibly to demographic and economic change. In the realm of occupational pensions, new corporate plans of the defined benefit or defined contribution type were introduced earlier.

Japan's demographic development is a major challenge. The country has one of the fastest ageing populations in the world. In fact, many observers consider the country to be the oldest society in the world even now. The current old-age dependency ratio stands at 30 and will worsen to 74 in 2050. During the same period, Japan's population will decrease from 128 million to 102 million. The fertility rate of 1.26 children per woman lies considerably below the rate of 2.1 that is needed to maintain the population. At the same time, Japan's life expectancy is among the highest in the world.

Nevertheless, we expect corporate pension assets to grow only 1% per year until 2015, starting from a basis of currently EUR 548.9 billion.

Public Pensions
National Pension System
The National Pension System was introduced in 1959 and is mandatory for all residents between 20 and 59 years of age. Contributions to the National Pension System are deducted from contributions for the employment-related portion of the public pension. For the self-employed, the contribution amounts to EUR 88 (JPY 13,860) a month. Monthly pension benefits after 40 years of working life and from age 65 onwards, the official retirement age for the National Pension System, amount to EUR 420 (JPY 66,000). Shorter contribution periods result in lower benefits. The system receives substantial subsidies of currently one-third of payments from the Japanese government, a share that will be raised to 50% by 2009.

Employee Pension Insurance
The second part of public pension provision is earnings-related. Private sector employees are covered by Employee Pension Insurance, which was introduced in1944. Public sector employees are covered by the Mutual Aid Association. The contribution rate to Employee Pension Insurance is 14.64% of wages, which is equally split between employers and employees. A part of this contribution is deducted for the National Pension System. Employees aged 60 and over with 25 years of contributions are entitled to benefits from the Employee Pension Insurance scheme. Retirement age will rise to 65 for men by 2025 and by 2030 for women. The Mutual Aid Association, which covers employees working in central and local governments as well as private school employees, operates mainly along the same lines.

Government Pension Investment Fund
While both the Employee Pension Insurance and the National Pension System operate on a pay-as-you-go basis, they have accumulated large reserves. Until 2000, these reserves were managed and invested by the Pension Welfare Corporation, which was established in 1961. In 2006, the Government Pension Investment Fund became an independent administrative institution to achieve a higher level of independence from the government, also in terms of its governance structure.
The Government Pension Investment Fund is the largest pension fund worldwide. In 2005, it directly managed assets of around EUR 560 billion (JPY 88 trillion). According to the Nomura Research Institute, its assets will amount to EUR 1.1 trillion (JPY 166.5 trillion) by the end of 2008.

Occupational Pensions
In Japan, voluntary occupational pensions come in a variety of forms. Traditionally, the occupational pension system comprised two schemes: Employee Pension Funds and Tax-Qualified Pension Plans. As these two were considered neither sustainable nor sufficient for retirement income security, defined contribution and defined benefit plans were introduced in 2001 and 2002. There is also the National Pension Fund Association, which is open to the self-employed and to employees whose employers do not operate a company pension scheme. Besides these schemes, employers also use book reserve arrangements. In addition, the government has created Smaller Enterprise Retirement Allowance Mutual Aid plans specifically for small businesses.

Employee Pension Funds
Employee Pension Funds were introduced in 1944 and cover firms with over 500 employees. The plans, which are defined benefit schemes, have two components. The first part substitutes Employee Pension Insurance. This means that firms may opt out of the public scheme on the condition that Employee Pension Funds provide 50% higher benefits than Employee Pension Insurance (10% for existing Employee Pension Funds). The rebate on the contribution to the Employee Pension Insurance scheme varies. The Ministry of Health, Labour and Welfare determines the exact rebate separately for each plan. The second component offers complementary pension benefits.

Employee Pension Funds are independent legal entities that are managed by a management committee comprising an equal number of employer and employee representatives. This committee decides whether to manage fund assets in-house or to contract management out to a trust bank or life insurance company. The assets can also be outsourced to the Pension Fund Association, the association of all Employee Pension Funds. Employees contribute 50% of the substitutional component of the Employee Pension Fund, while employer contributions to the additional component are usually higher than those of the employees.

The part of Employee Pension Funds that replaces Employee Pension Insurance is subject to the same benefit formula as applied to the Employee Pension Insurance itself and is paid as an annuity. At least half of the additional benefits from Employee Pension Funds should also be paid as annuities. Employee Pension Funds must contribute to a compulsory insolvency insurance scheme that protects their assets. All other occupational schemes are not required to do so.

Employer and employee contributions are tax-deductible without limits. Investment income is taxed in principle, but only under rare conditions. However, the tax is frozen until 2009. A portion of benefits is taxed as income; the amount depends on total pension income.

Tax-Qualified Pension Plan Scheme
The Tax-Qualified Pension Plan Scheme was established in 1965 and targets smaller companies with 15 or more employees. The plans are funded by employers, and voluntary employee contributions are possible, but rare. Benefits can be paid as an annuity or as a lump sum. The Tax-Qualified Pension Plan Scheme was underfunded and lacked protection of plan participants. Moreover, the rights and responsibilities of employers and plan members were not clearly defined. For these reasons, pension legislation in 2000 determined that no new Tax-Qualified Pension Plan Scheme could be established, and that existing ones either had to be converted into the new defined benefit or defined contribution schemes or wound up by 2012. They can be also converted into the Smaller Enterprise Retirement Allowance Mutual Aid scheme. The new corporate schemes were also introduced due to the demand for "pure" company pension schemes that were not related to the public scheme like Employee Pension Funds are.

New Corporate Pension Schemes
The introduction of the defined contribution scheme in 2001 and the defined benefit scheme in 2002 was the result of the lacking sustainability of existing corporate schemes. Employers were allowed to return the portion of Employee Pension Funds that substituted Employee Pension Insurance and transfer the complementary component to the new corporate schemes. As mentioned, the Tax Qualified Pension Plan Schemes can be converted into the new schemes. The new plans are not mutually exclusive; employers can operate defined benefit and defined contribution plans simultaneously. Similar to all Japanese pension funds, the prudent person principle applies.

Defined benefit schemes
Defined benefit plans can be of the fund or the contract type; both can be established by one or a group of employers. In the case of the former, plans must be implemented through the establishment of a pension fund, which is an independent legal entity that is completely separate from the sponsoring employer. It is managed by a management committee comprising an equal number of employer and employee representatives, just like Employee Pension Funds. Contract type plans are concluded with banks or life insurance companies. In both cases, the plans must be based on a pension contract between the sponsoring employer(s) and their employees. Among other things, the plans must regulate contribution rates and define benefit qualifying conditions and structures/formulas. Furthermore, sponsoring employer(s) must obtain the approval of the Ministry of Health, Labour and Welfare. While fund-type plans may manage assets in-house, they tend to outsource to banks or life insurance companies.
Employer contributions for defined benefit plans are tax-deductible without limits. Employee contributions are permitted and are tax-deductible up to a limit of EUR 318 (JPY 50,000) per year. Investment income is taxed (at a rate of 1.173%), but this tax will be frozen until 2009. While a portion of pension benefits is considered taxable income, the level of tax exemption depends on total pension income.

Defined contribution schemes
Defined contribution plans also come in two forms. Corporate defined contribution plans can be established by single employers and must be implemented through a contract with a pension management organisation, such as trust banks, insurers, or fund managers. These institutions must be registered with the Ministry of Health, Labour and Welfare. Each plan must be based on a contract between the sponsoring employer and its employees. The contract with the provider must be approved by the Ministry of Health, Labour and Welfare. Self-employed persons or employees whose employer does not operate an occupational pension plan can conclude a personal defined contribution plan. These plans are managed by the National Pension Fund Association, which is a public body. As is common with defined contribution plans, they are fully portable. If employees switch to a new employer that does not operate a pension plan, they must transfer their accumulated capital to a personal plan at the National Pension Fund Association.

Employee contributions to corporate defined contribution plans are prohibited; employers pay the total contribution. The plan must offer its members a choice among at least three investment options. At least one of these must guarantee the preservation of the principal. Members must have the opportunity to switch every three months. Defined contribution plans vest after three years of employment. The accumulated capital can be withdrawn as a lump sum. The tax deduction possible depends on the number of plans a company operates. If the employer operates only the defined contribution plan, the tax-deductible yearly contribution amounts to EUR 3,514 (JPY 552,000) per employee. If it also sponsors a defined benefit plan, the limit is lowered to half of that sum. The taxation of defined contribution plans is the same as that of defined benefit plans.

The challenges of ageing in Japan are considerable. It already has one of the oldest populations in the world, if not the oldest. For this reason, pension reforms aim to achieve greater system sustainability. The automatic balancing mechanism for public pensions was inspired by reforms in Sweden, but adjusted to the Japanese environment. It provides a flexible and self-controlling mechanism to adjust to demographic changes. Similarly, the termination of the Tax- Qualified Pension Plan Schemes within the next five years and the introduction of new corporate DB and DC schemes will lead to higher retirement income security, as these measures are a means of coping with underfunding problems.

Compiled by Allianz Global Investors