The problem of investing pension funds in JGBs

KYOTO – The Government Pension Investment Fund earned ¥2.4 trillion through management of its reserve fund in fiscal 2018 for a rate of return of 1.5 percent, according to its report released in early July. It suffered an appraisal loss of ¥14.8 trillion in the October-December period due to sharp falls in Japanese and overseas stock markets, but the GPIF’s whole-year earnings became positive thanks to the recovery in share prices in the January-March quarter, which brought ¥9.1 trillion in earnings.

As it has long been pointed out, arguing over performance of the public pension fund over a short cycle like a quarter or a year is extremely inappropriate since they are supposed to be managed over a very long term.

Some members of the opposition camp have criticized the administration of Prime Minister Shinzo Abe for exposing the public pension reserve — the assets of the people — to danger by reducing the share of Japanese government bonds while increasing that of Japanese and foreign shares as well as foreign bonds in the asset allocation of the GPIF.

However, such criticism is based on the misunderstanding of long-term and diversified stock investment as a gamble. Adding stocks, with the risk sufficiently diversified, to the GPIF’s portfolio does lead to a greater fluctuation in short- and medium-term return on the investment but will enable higher returns over the long term that matches the risk premium. This is the ABCs of investment.

In fact, as the chart shows, the GPIF has since becoming an independent incorporated administrative agency in 2006 scored an accumulated investment gain of ¥51.7 trillion through fiscal 2018, for an average yearly rate of return of 3.2 percent, although it suffered a big appraisal loss in fiscal 2007 and 2008 due to the financial crisis in the United States. In the five years since fiscal 2014, it gained ¥30.2 trillion for an average annual return rate of 4.4 percent.

How is the GPIF positioned in the nation’s public pension system? Japan’s public pension adopts a pay-as-you-go system, in which the working generations pay for the benefits to retirees. This is distinguished from an advance funding system. If a ceiling is set on the burden of the working generations to cover the expense of pension benefits, the benefits to be paid out for future retirees will increase only when the population and the per capita income of the working population increase. If the reverse conditions set in, the benefits for the future retirees will decline. This is the basic principle of the current pension system’s macro slide mechanism.

Even so, it is premature to be pessimistic and think that a decline in the public pension benefits is inevitable given the aging of the population and the low birthrate. Even against this backdrop there will be a way to prevent the pool of working generations from shrinking. Fortunately, Japan has among the longest life expectancy in the world, and the healthy life expectancy of its population has also increased significantly. In coming years, there will be roughly 8 million to 9 million people in the 65 to 69 age group. If people stay in the labor market five years longer instead of retiring between the ages of 60 and 65, that will add millions to the active labor force.

By the way, if a public pension system is operated completely under a pay-as-you-go system, there will be no need to create a reserve fund. About 90 percent of the resources of Japan’s public pension system each year are covered by premiums paid that year by the working generations and contributions from the government. Although earnings and reserves of the GPIF will be gradually spent down, the fund is managed so that its contribution will account for only about 10 percent of the pension system’s fiscal resources over the coming 100 years.

Even though the earnings are projected to amount to only 10 percent of resources of the pension system, the GPIF explains why it has to manage the fund worth as much as ¥160 trillion in investment the following way. Japan’s population is rapidly aging and the number of children is shrinking. If the pension benefits are to be covered solely by the premiums paid by the working generations, the burden shouldered by future working generations would become too heavy. Therefore, a portion of the premiums not used in paying for the current benefits is saved in a reserve fund.

The reserve fund, which now amounts to ¥160 trillion, is for easing — even if partially — the generational disparity in pension benefits arising from the aging population under the pay-as-you-go system and reduce the burden of future working generations.

However, a contradiction hardly discussed is hidden in this point. If money from the reserve fund of the public pension system is invested 100 percent in Japanese government bonds, will it make up for the gap across generations in terms of the burden and pension benefits? Who is going to pay the interest on and redemption money on such bonds?

There is no other choice but to have future working generations cover the cost in the taxes they pay. Whether the future working generations bear the full cost of paying for the benefits to future retirees under a pure pay-as-you-go system without the reserve fund, or whether money from the reserve fund is invested in government bonds to help cover the payment of benefits to future retirees, it makes no difference because future working generations will bear on the burden anyway.

This point will become even clearer if one thinks of the government’s consolidated balance sheet, which includes the GPIF. Japanese government bonds held by the GPIF as assets are offset by the government’s debts (government bonds). This means that government bonds held by the GPIF do not make assets for the future generations.

But if the GPIF holds shares in private sector companies, they will not be offset in such a way. If the GPIF invests in foreign stocks and bonds, the dividend and interest revenue the GPIF will receive in the future will constitute income transfer from overseas to Japan, thus contributing to narrowing the generational gap in the burden of and benefits from the pension system. For the purpose of reducing this gap, the opposition parties’ argument that the GPIF should invest its reserve fund in Japanese government bonds is meaningless. I hope a rational debate will be held on this issue.

Masaharu Takenaka is a professor of economics at Ryukoku University in Kyoto.