Japan’s public pension: The great vulnerability to deflation

Author: Mitsuo Hosen, ESRI

Deflation since the mid-1990s has had a serious negative impact on the Japanese economy in many respects. This essay focuses on its impact on public pension finance. In the current institutional setting in Japan, deflation increases the real pension benefit level, while keeping the real pension contribution schedule constant; it thus has a negative impact on Japan’s public pension finance. In this sense, Japan’s public pension schemes are not neutral to deflation. This essay is intended to explain this non-neutrality and to quantify the impact of deflation on public pension finance.

There are three major problems with the current public pension schemes under deflationary circumstances. Firstly, the actual pension benefit level has been higher than the permanent level on a provisional basis since the financial year 2000 primarily because of deflation. Prior to the 2004 Public Pension Reform, the most fundamental reform in recent history, the pension benefit level in a fiscal year (April-March) was indexed to the CPI of the previous calendar year, but this rule was not observed in the early 2000s for political reasons. Although the CPI declined by 0.3 per cent in 1999, 0.7 per cent in 2000, and 0.7 per cent in 2001, the pension benefit level was maintained in the financial years 2000, 2001 and 2002 on a provisional basis. As a result, the actual benefit level in 2002 was 1.7 per cent higher than the permanent level, which was fully indexed to the CPI. In the 2004 Public Pension Reform, it was expected that the 1.7 per cent gap would be eliminated by inflation in a couple of years by holding the provisional level constant and by raising the permanent level by the inflation rate. However, the gap has not narrowed since then, essentially because of deflation. Under deflationary circumstances, both the provisional and permanent levels are reduced. The gap was 1.7 per cent in the financial year 2008, 0.8 per cent in 2009, 2.2 per cent in 2010, and it is expected to become 2.5 per cent in 2011 and 2012 (The reasons for this widening gap are rather technical and not explained here).

Secondly, the automatic adjustment mechanism, which was introduced in the 2004 Reform to ensure the financial viability of Japan’s public pension schemes in the face of population ageing, has not been activated so far and is not expected to be activated until the financial year 2015 or so. Again, this is primarily due to deflation, since this mechanism is only activated after the permanent level exceeds the provisional level.  In the 2004 Reform, the pension benefit level is basically indexed to inflation, but it is automatically reduced annually by the sum of the following two rates as well:

1)     the rate of decrease in the number of covered persons by public pension schemes

2)     the projected average annual rate of increase in life expectancy (0.3 per cent).

Although this automatic adjustment mechanism is the most important device introduced in the 2004 Reform to ensure financial viability of public pension schemes, this mechanism has not been activated, and it will only be activated after the permanent benefit level exceeds the provisional benefit level.

Thirdly, even after the automatic adjustment mechanism is activated at some point in time, following a period of positive inflation, no adjustment will be actually made if deflation resurfaces. If the rate of inflation is positive but lower than the adjustment rate, only a partial adjustment equal to the inflation rate will actually be made.

The total impact of the first and second problems above on public pension finance until the financial year 2015 is quantitatively examined in the full-length paper. That is, the real overpayment due to the difference between the actual benefit level and the benefit level envisaged in the 2004 Reform, which assumes activation of the automatic adjustment mechanism around 2008, is estimated. The estimated real overpayment is ¥1.7 trillion, which is 0.3 per cent of the 1999 Financial-Year Gross Domestic Product for the financial year 2010; ¥2.3 trillion, or 0.5 per cent for 2011; ¥2.7 trillion or 0.5 per cent for 2012, and so on. The total real overpayment between the financial years 2000-2015 is estimated at ¥20.2 trillion in 1999 prices, which is 4.1 per cent of FY1999 GDP. This overpayment is due to the following two factors: 1) the fact per se that the actual provisional benefit level exceeds the permanent level; and, as a consequence, 2) non-activation of the automatic adjustment mechanism.

Japan’s public pension schemes seem to be designed on the assumption that inflation is the norm and deflation is an exception, as was the case until the first half of the 1990s. If the Japanese economy is unable to escape from deflation for long, this arrangement will have an even larger detrimental impact on the health of public pension finance and on that of the general government fiscal balance as well. Putting an end to deflation is the first priority, but at the same time it is imperative to improve Japan’s public pension schemes to avoid financial impairment by deflation.

Mitsuo Hosen is an Executive Research Fellow at the Economic and Social Research Institute, Cabinet Office, Tokyo, Japan. This essay summarises a longer paper.