The Health, Labor and Welfare Ministry’s Social Security Council in late August released its report to examine sustainability of the public pension system every five years. This time, the report received particular attention since it followed the recent controversy as to whether public pension benefits are enough to cover people’s retirement expenses. However, misguided comments on the issue flooded social media and blogs, and some of the mass-media reports tended to present a one-sided coverage.

What was conspicuous first were the comments expressing concern — and those that seemed aimed at fueling people’s anxiety — that the public pension system might collapse and leave future retirees without the benefits.

Today’s pubic pension system in Japan is operated by the pay-as-you-go method, instead of the funded system. Under the funded system, people lay aside premiums while they are working and receive the benefits including investment gains after they retire. While the simplest method is to invest premiums from an individual account, it is not impossible to invest pooled premiums.

In the pay-as-you-go method, which is designed for the younger generations to support the older generations, premiums that people currently working pay into the system are used to pay the benefits for people in retirement. As long as the working generations of the future continue to pay premiums, public pension finance cannot collapse and payment of the benefits will not stop. However, benefits for future generations will have to decline in relative terms under an aging population with a falling number of births.

Concerning this point, there is an argument that the government had no choice but to shift to the pay-as-you-go system without sufficient discussions since the 1980s on because its fundamental errors undermined public pension finance. What the argument means is as follows: In setting the amount of premiums to be paid up to the 1970s, it was assumed that while growth of wages and the economy would be flat, investment gains on the premiums would reach 5 to 6 percent — an unreasonably high level. Thus the estimate of investment gains on the pool of premiums was excessively high.

As a result, it became inevitable for the government to raise the premiums whenever it reviewed its levels, which eventually forced the government to transition to the pay-as-you-go system, according to economist Yukio Noguchi (in his Sept. 11 and 25, 2010 articles on Diamond Online).

Noguchi appears to think that the government’s errors on this point had a more serious impact on the public pension system than the aging of Japan’s population that progressed faster than had been anticipated. But I think that his contention is open to question.

At any rate, it will be extremely difficult to go back to the funded method. Since pension benefits have already been paid to retirees for such a long period by using the premiums set aside by people in working generations under the pay-as-you-go method, a future shift back to the funded system will require funding to close the gap that will far exceed the current reserves of some ¥200 trillion.

The second popular misunderstanding is the argument that even if payment of pension benefits continues, significant cuts to the amount of the benefits will be unavoidable — and that to cover up such a prospect, the scenarios of economic conditions used in the pension finance report are set in optimistic terms. Under the revision of the public pension system in 2004, the level of premium payments was fixed at a certain level in order to prevent increases in future premium payments. Automatic adjustment of the benefits based on macroeconomic indexation has also been introduced so that benefits will be paid out of the financial resources within that range.

The table shows the six cases — ranging from optimistic to pessimistic — of the pension finances shown in the Social Security Council report, each showing the anticipated ratio of pension benefits to income of the working generation at that time (income substitution rate) under varying economic conditions.

In the six pension finance cases, the annual inflation rate was given in a range from 0.5 to 2 percent (as compared to the 1990-2018 average of 0.5 percent), real wage growth from 0.4 to 1.6 percent (0.3 percent), investment return of pension reserves from 0.8 to 3 percent (3 percent), real GDP growth from minus 0.5 percent to a 1.3 percent growth (1 percent) and total factor productivity growth from 0.3 to 1.3 percent (0.9 percent).

The income substitution rate is calculated by dividing the pension benefits that a model single-income household of a company employee and his wife receive when they turn 65, by the average after-tax wage income of the working generation. At present, the rate is 62 percent, and the government has set a target of keeping the rate at no less than 50 percent.

Contrary to a prevalent misunderstanding, a decline in the income substitution rate does not mean cuts to the nominal pension benefits. The figure represents the ratio of real pension benefits to the average inflation-adjusted take-home income of the working generation. Some people appear to think that nominal or real pension benefits go down by as much as the income substitution rate falls. But such a thing will not happen as long as real income keeps going up, albeit moderately.

Among the various elements of economic conditions, what’s particularly important to the pension finances will be total factor productivity growth, real wage growth and investment return of pension reserves.

I do not think the assumed range given to each of these factors is too optimistic compared with the long-term average since 1990 and the trend of the last several years. The labor participation rate has in fact been going up in recent years as more women and elderly workers join the labor force, and the scenario assumed in the report seems reasonable.

The third point to note is that the more pessimistic scenario — from case IV to VI — shows that downward adjustments to the pension benefits will proceed to the point that income substitution rate would dip below 50 percent.

To deal with these cases, the latest report identifies two options to beef up the pension finances. One is to expand the coverage of the pension system for corporate employees so that workers who have been excluded due to their wage conditions and the size of their employer can join.

The other is to extend the upper limit to the period when people pay into the basic pension scheme from the current 40 years to 45 years — and increase the amount of basic pension benefits accordingly. Both options are known to be quite effective in shoring up the pension system.

In the changes confronting Japan, the rapid aging of the population is, fortunately, accompanied by the extension of the average people’s healthy life expectancy.

Reform of the public pension system in accordance with the nation’s demographic changes is becoming increasingly unavoidable.

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

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