Back to Contents of Issue: January 2003
by Darrel Whitten
DURING THE US BULL market between 1982 and 2000, the mantra was "buy and hold" and "stocks for the long run." The argument was that the average return on stocks in the US over the past century or so has been around 6.5 percent -- or much better than bond yields. Moreover, it was argued, the premium that investors demanded for more "volatile" returns in the stock market was too high, judging by the experience of the 18-year bull market. Therefore, the Dow Jones industrial average was supposed to have soared to 40,000 or so.
What someone forgot to mention, however, is that in reality, dividend yields actually provided the bulk of the long-term average return on stocks in these calculations. Moreover, taking the earnings risk premium for the US market between 1982 and 2000 was like taking the Japanese market's earnings risk premium from the 1970s to 1989 -- you only looked at the major bull-market phase and ignored the rest. Over the very long run, bear markets in equities have lasted 20 years on several occasions, and for ten years much more often. In other words, "buy and hold" is not such a good idea in a secular bear market.
Japan's public pension system had long been a means of pooling personal financial assets at the government level and using them to underwrite government bonds and invest in economic infrastructure projects through the Ministry of Finance's Trust Fund Bureau and the Fiscal Investment and Loan Program (FILP). Moreover, the money that was invested in financial markets through the Pension Welfare Service Public Corp., or Nempuku, and through the welfare pension funds administered by corporations for their employees was restricted by a government-mandated asset allocation -- the infamous 50-30-30-20 rule. The rule says pension funds had to maintain 50 percent of their pension assets in principal-guaranteed instruments, while a maximum of 30 percent could be held in equities, of which a maximum of 30 percent could be held in overseas securities, with a maximum of 20 percent of total assets held in real estate investments.
For years, asset managers railed against this government-mandated asset allocation. The allocation, it was claimed, doomed Japanese pension funds to substandard returns, because while the stock market was soaring, fixed income returns were in a secular decline. Because the expected returns on domestic and overseas stocks were higher, the theory of portfolio diversification would dictate that a higher level of domestic and foreign equities would reduce risk while maximizing potential returns.
The other structural impediment to "fair" market returns for Japan's pensioners and savers was the archaic, developing-country infrastructure that funneled the nation's savings into government bonds and social infrastructure projects through FILP. Over the years, it had become the "shadow budget" and a pork barrel for politicians. To manage money in the financial markets, Nempuku had to actually borrow the money from the Trust Fund Bureau at what were essentially long-term bond rates. Thus the fund began with a loss equivalent to the long-term bond yield and had to produce market returns that not only provided for future pension liabilities, but also the borrowing costs of the funds.
Dismantling The Old System
The government decided to thoroughly review the entire plan and to basically end the link of the nation's pension funds with the Trust Fund Bureau and FILP. The pool of public pension funds was transferred to the Government Pension Investment Fund (GPIF), a new organization that also absorbed the old Nempuku. It did this because it was obvious that both the FILP method of funding and Nempuku were no longer working. Private sector researchers estimated that the nonperforming loans of government-affiliated corporations that received funding from FILP had reached about JPY84 trillion, while Nempuku was also running up cumulative losses amounting to about JPY2.8 trillion by fiscal 2000. The idea was to not only transfer the funds being managed in financial markets by Nempuku, but also to manage the JPY130 trillion still being controlled by the Trust Fund Bureau. An immediate transfer, however, would be a disaster for FILP. Consequently, a plan was implemented where this JPY130 trillion would be gradually transferred to the GPIF by fiscal 2006.
The key assumption in revamping administration of the nation's pension funds was that putting these funds to work in the markets would, in the end, produce economic returns for the nation's pensioners, instead of being merely a huge cookie jar for politicians and their cohorts to dip into whenever the economy hits a rough spot. Politicians are notorious for using the funds to issue more government bonds to fund fiscal stimulus packages, or for pressuring the nation's public pension funds to buy stocks when the stock market looked to be dropping through psychological resistance zones.
Given these structural and political issues surrounding the public pension system, it is not surprising that the investment track record for the nation's public pension funds has been horrible during the Heisei Malaise. The GPIF was established in fiscal 2001, and many of the cumulative losses in its portfolio were inherited from the old Nempuku. As of fiscal 2001, the fund was still obligated to pay the Finance Ministry interest on JPY24 trillion yen that was "borrowed" by Nempuku from the Trust Fund Bureau. However, the GPIF under-performed most of its benchmarks last fiscal year and lost about JPY1 trillion on domestic stock investments. The losses continue to the tune of JPY834.3 billion in the April-June period of this fiscal year alone. For corporate pension funds, companies can choose to expense current earnings, filling the gap between pension-funding shortfalls that arise because of the gap in actual returns and projected returns. In the GPIF's case, there is no separate earnings flow with which to offset these enormous cumulative losses -- except to ask current contributors to the plan to pay more.
According to the fund's medium-term asset allocation policy, its total exposure to domestic equities is slated to rise from 5 percent now to 12 percent. For foreign equities, the percentage will rise from 3 to 8 for a total equity weighting of 20 percent versus the current 8 percent. Ostensibly (based on current pension reserves), the government fund's exposure to Japanese stocks would rise from JPY5.9 trillion to JPY17.6 trillion over this period, or by JPY2.3 trillion per year. On the surface, this is good news for the stock market, the asset managers who are vying for GPIF mandates and the brokers who will be executing the trades. In fiscal 2001, the fund paid some JPY30.8 billion in commissions.
The Problem with Bull Market Assumptions
However, MoneyWatch has problems with the underlying assumptions in this medium-term asset allocation scenario. In a secular bull market, the assertions about expected returns were correct. Making money in stocks (at least above and beyond bond returns and inflation) was easy -- the rising tide lifted all boats. In a secular bear market, however, all of these assertions are dead wrong. Indeed, as Andrew Smithers and Stephen Wright pointed out in Valuing Wall Street: Protecting Wealth in Turbulent Markets, in a secular bear market, the real name of the game is protecting wealth, not trying to increase it.
Besides the lingering structural impediments and political meddling, the other time bomb for Japan's pension funds is demographics. When the population was young, and the number of those entering the work force was larger than those retiring, there was a structural surplus in the nation's pension funds because the growing working population's contribution to the national pension pool was increasing faster than the amount of withdrawals by retiring workers. This was the "accumulation phase." With rapid aging of the population, however, the opposite occurs. The growth of withdrawals from the pension pool begins to exceed the growth in contributions from new workers entering the pension system. In other words, the fund enters the "payout phase." Structurally, Japan's pension system has entered the "payout phase," which greatly increases the pressure to produce returns for both new pensioners and projected pension fund liabilities, as calculated by benchmark investment returns (currently 4 percent for the GPIF).
Management of the nation's pension funds has begun to structurally shift to equities at just the wrong time. Just like the assumptions that drove the current glut of new office space in Tokyo (i.e., by the time the buildings are completed, the economy and the property market will have recovered), the assumption that the stock market will have recovered sufficiently by fiscal 2006 to outperform the bond market sounds plausible enough now, given that the Tokyo stock market has plunged 80 percent from its 1989 peak. However, one has to consider the mature nature of these pension funds. When it is still in the accumulation stage, a pension fund is like a young couple in their 30s -- their capacity for risk is higher, and they have time to make up for their investment mistakes. Therefore, their weight in equities can be much higher. When people near retirement, their capacity for risk is noticeably lower, and they have no time to make up for investment mistakes. Consequently, their preference is for current income (dividends and bond coupons) rather than capital gains.
Dose of Reality
Now is not the time to increase the market risk profile of the Government Pension Investment Fund. Aside from the demographics, the fund's problems are further compounded because corporate bankruptcies are soaring and more funds are giving up on managing the government welfare pension portion of in-house pension plans. Many now use the word "declining" when describing the condition of employee pension funds. A record 29 employee pension funds were dissolved in fiscal 2000, the fourth consecutive year of double-digit figures. A total of 103 funds have been dissolved since the system was started in 1966.
Asset managers subcontracted by the government to handle pension funds have not demonstrated any particular ability to insulate public pension money from the implosion of capital values in the Japanese stock market. The major investment trust companies in Japan themselves are seeing two digit declines in their assets under management. The top three -- Nomura, Daiwa and Nikko -- have seen their net asset values shrink by 37 percent since last September alone, or by JPY13.7 trillion. They have even managed to lose money on virtually risk-free money market funds by investing in Enron and Argentine bonds.
The structure of GPIF administration also leaves much to be desired. Given the less-than-a-decade history of direct management of pension assets by plan sponsors, it is no exaggeration to say that most of the people responsible are newcomers to the world of pensions and payouts.
The fund's critics claim that the GPIF needs a dose of reality, and MoneyWatch heartily agrees with those critics, especially given the gravity of the current scenario. If the GPIF were enjoying a surplus of reserves over future pension liabilities, it could afford to assume more risk. But today the fund continues to accumulate investment losses, and under-funding liabilities continue to grow. Now is not the time to increase the fund's risk profile. @
Darrel Whitten writes MoneyWatch, a free email newsletter, every week for J@pan Inc. Go to www.japaninc.com/subscribe_news.html to subscribe.
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