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quarta-feira, setembro 02, 2009

UBS Tuesday Macro Sales Ideas / Sales Thoughts - Japan's slow road to pension default !!!

UBS Equity Derivatives Macro Sales Ideas / Sales Thoughts – (By Andrew Lees 44 207 568 4350). Tuesday 1st September 2009

Please note these ideas may differ from UBS Research / UBS house view

Japan’s slow road to pension default

As we all know Japan faces a demographic problem. Over the next 5 years as the 7 million baby boomers from immediately after the war retire, the old age dependency ratio is expected to rise by 8%. The dependency ratio will continue to rise for a further 20 years. This year the Japanese state pension fund will have negative cash flow, although they suggest it will only be temporary. Given just how dire the situation is, and how Japan is set to experience the problem before the other major western economies, I wondered how far it was through the process of defaulting, and therefore should Japan start to trade at a premium to other economies that are still clinging on to the false belief that they can meet their commitments.

There are defaults happening, but so far they are relatively small scale. One such default however is symbolic with defaults of old. On reaching the ripe old age of 100 the state gives a silver sake cup, but in the good old tradition of debasement, Japan has cut the silver used in the cast from 94 grams to just 63 grams, a 32% debasement.

Unfortunately a similar debasement or default is needed across the whole pension distribution, but nothing so radical has yet to be discussed. The accrual of benefits has been cut from 75bpts to 71.25bpts, whilst the benefits have been linked to CPI after the age of 65 rather than linked to wage inflation which is normally about 1% higher. In periods of deflation however there has been no deflation linkage so the pension has risen in real terms. If you are lucky enough to live to the age of 87 your benefit will be reduced by 20% so this is likely to mean that people will have to save some of their pension. Finally the normal pensionable age for earnings-related old age benefits is to be increased step by step from 60 presently to 65 between 2013 and 2025. Whilst this is encouraging, so far there has been little sign of an increase in the participation rate and according to the out-going finance minister “I don’t think this problem will be solved unless Japanese work until perhaps 70 or 75 years old”.

The new ruling party, in the run up to the elections, voiced promises to look after the “grannies and granddads” which it said had been denied proper care and rightful pensions. It also promised a sweeping reform that would lift the fertility rate by giving JPY26,000 (USD280) a month in child allowance. Whilst electioneering, a lot will be said that won’t later be carried out, it is pretty clear that the party wasn’t wanting to default on the grey vote – (not only is the grey vote becoming larger, but senior citizens are strong voters whilst future generations have weak or no political powers), and at the same time were happy to make promises to other parts of the population. Assuming the fertility rate does start to rise – (it is estimated that it will rise to 1.75% due to these benefits), then Japan will face the combined effect of a rising childhood dependency ratio as well as old age dependency ratio, making the situation that much worse particularly if women leave the workforce to bring up the children.

In 2003 Japan’s Employers Pension Insurance System (Kosei Nenkin Hoken (KNH)) announced that contributions would be lifted by 0.354% every year from 13.58% until they reach a cap at 18.3%. Rather than defaulting on the commitments, workers are effectively being screwed even further; exactly the opposite of what needs to happen. The pension liabilities are estimated at JPY720trn, while pension assets are only JPY270trn which is made up of a funded reserve of JPY170trn plus transfers from general revenue of JPY100trn. As for the KNH reserve fund, the contributions have already been invested in the construction of highways, railways, bridges, airports and other public projects. Whether these investments end up yielding a return or are the “bridges to nowhere” only time will tell.

Even before addressing the demographics, the departing cabinet could only hope for a primary budget balance if all non-social security costs are held constant in nominal terms from 2012 and the consumption tax is raised by 5%, a policy that was controversial within the LDP and outright opposed by the DPJ. The Welfare Ministry data showed social security spending reaching JPY42trn (USD430bn) in 2015, up 42% from 2006’s level. This figure does not even address the related issues such as needing more doctors and nurses. According to a report by Hitotsubashi University – (http://www.ier.hit-u.ac.jp/pie/Japanese/discussionpaper/dp2003/dp194/text.pdf) – the necessary hikes in contribution rates will induce an incentive problem such that for the younger cohorts, the internal rate of return in the social security pension system is extremely low and may even become negative.As it is the Keizai-Douyukai employer group forecasts that the KNH is in fact facing bankruptcy, and that if it does go into liquidation the entitled benefits would be cut by around 30%.

As it happens, Sweden, Italy, Poland and Latvia are much further along the line of defaulting on their pensions by adopting a notional defined contribution plan whereby benefits are linked directly to personal contributions. Perhaps as these pensions mature, they will be insufficient to support the retiree and the government may have to commit more funds, but for the moment at least it appears that the default has happened. Any change going forward therefore is likely to be less painful than will be the case with Japan where it still has to bite the bullet. In Sweden’s case there is an automatic balance mechanism which inexorably cuts the per capita benefits relative to the wages. It is believed that when the KNH contributions reach their maximum in 2017, then the government may try to switch to a Swedish style model.

The table below shows intergenerational (or inter-temporal) accounting. I have taken the data from a demographics book but it is supposedly made public by the countries included in the table. It shows the relative fiscal burdens faced by future generations compared with today’s workers if existing pension liabilities are met in full. The data is out of date and Brazil’s tax imbalance was not due to demographic reasons and can be ignored. As you can see at the time of issue in 1995 Japan faced the largest inter-temporal imbalance, but it also seems that it has so far done less than other countries to default. Italy for example, which is the next worst, appears to have adopted a national defined contribution plan.


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