July 2013
NIRA Report

Reforming Japan’s Government Bond-financed Social Security Systemby Overcoming “Silver Democracy”

Executive Summary

Japan’s social security system is entirely supported by the annual issuance ofgovernment bonds, and the scale of these bond issues is expected to increase
continuously in the future. The social security funds which should provide a reserveagainst the peak of the aging of Japan’s population in the first half of the 2040s havealready begun to be accessed, and there is a possibility that they could be depleted inaround 20 years. Following the depletion of these funds, it will be necessary to dependon additional issuance of government bonds for the same amount as had previously
been withdrawn from the funds each year. The recognition of this possibility has thepotential to undermine confidence in Japanese government bonds.
In order to avoid this situation and ensure that social security funds are maintained until
2050, beyond the peak period of the aging of the nation’s population, it will be essential
to reduce current pension benefits. This will undoubtedly be difficult in a “silverdemocracy,” in which elderly citizens possess considerable political power. However, if
those elderly citizens were to be made sufficiently aware of the high degree of risk
inherent in a pension structure in which benefits are dependent on the issuing ofgovernment bonds, it would not be impossible to reach a consensus regarding thestabilization of the pension system by reducing benefits. Conscientious efforts to ensurethat the public is thoroughly aware of the risk in the current pension system will be an
absolute precondition for the realization of such a consensus. To this end, it will benecessary to establish an independent organization to conduct accounting audits ofpublic pension insurance, following the example of the U.S. Financial Management
Service which publishes the annual Statement of Social Insurance.
1. The Risks inherent in a Deficit Bond-financed Social Security System
Depletion of Public Pension Reserves
Against the background of the rapid aging of the population and long-term economic
stagnation, the scale of social security benefits payments is continuing to increase far1

beyond the scale of the insurance premiums being contributed by working generations.
The difference is made up by the annual issuance of government bonds, and the scale ofthis bond issuance is expected to increase still further in future with the aging of thebaby boom generation to 75 and above.
This continuous increase in the scale of benefits payments is not something that can beresolved by increasing Japan’s rate of consumption tax from 5% to 10%. The current
situation, in which deficit bonds are being continuously issued and the burden is being
passed on to later generations, cannot be sustained for the medium- to long-term, and it
is possible that this might represent a major factor in undermining confidence in theJapanese government bond market that has financed the Public Pension scheme.
The Ministry of Health, Labour and Welfare (MHLW) has appealed to the concept ofpublic pensions which are “secure for a century,” referring to the maintenance ofpension reserves until around 2100. However, contrary to initial forecasts, the social
security funds which should provide a reserve against the peak of Japan’s aging havebeen depleted by almost 20% in the past five years.
Projected Figures which diverge from Reality
A major reason for the current unanticipated situation with regard to Japan’s pension
fund is the fact that long-term estimates of the level of the fund were based onassumptions which diverged significantly from economic reality. Because of this,essential reforms in the social security system which should have been conducted havebeen put off for the future. The 2004 Actuarial Valuation of the Public Pension Plans
published by the MHLW was based on the optimistic assumption that a rate ofinvestment return of 3.2% for the pension fund and a wage increase rate of 2.1% (bothnominal values) would be maintained over the long term. Following this, in the 2009
Actuarial Valuation of the Public Pension Plans, which should have taken into
consideration the fact that these figures diverged from actual values, the indicators wereincreased still further, to a rate of investment return of 4.1% and a wage increase rate of2.5%. This further increased the discrepancy between these figures and the actual
figures for the rate of investment return and wage increase rate for the pension fundmanaged independently by the Government Pension Investment Fund (GPIF)1.
Assuming hypothetically that no pension reforms are initiated and the pension reserves
are depleted, government bonds to a value equivalent to the amount previously
withdrawn annually from the fund (an average of approximately 10 trillion yen) would
then need to be continuously issued, and this amount would be added to the averageannual amount issued over the past ten years (approximately 35 trillion yen). This mustnecessarily have a significant impact on the bond market. Because of this, there is apossibility that confidence risk among investors in Japanese government bonds will
become higher the lower the pension reserve becomes. Assuming that a new bond issue
proved difficult, it would be impossible to avoid a significant reduction in pension
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benefits and other social security expenses, in order to bring them within the scope ofrevenue from social insurance premium revenues (around 60% of the current value ofbenefits). This is the “hard landing” scenario.
Figure 1

Outlook for pension funds (Total of employees’ and public pensions)(Note)
The actual figure for 2012 is the figure at the end of the second quarter.
(Source) Review of Operations in Fiscal 2011and the 2009 Actuarial Valuation of the PublicPension Plan Ministry of Health, Labour and Welfare

2. Scenario enabling Maintenance of a Public Pension SystemAvoiding the Hard Landing Scenario
In order to avoid a hard landing of this type, the desirable scenario would be to realize apension system that is secure for at least 40 years, taking us past the peak of Japan’s
aging process to around 2050, on the basis of more realistic economic indicators. An
attempt to adjust burdens and benefits within the system would represent an essentialfactor in realizing this soft landing scenario.
In Case 1), in which the actual value for the rate of investment return for the pension
fund, recorded from 2001 to 2011 by the GPIF, was substituted for the figure used in thecase producing a pension system which would be “secure for 100 years” in the 20093

Actuarial Valuation of the Public Pension Plan, the depletion of the fund occurs earlier
than the Actuarial Valuation case, in 2060. Cases 2) and 3) employ the same rate ofinvestment return, but reduce the nominal wage increase rate to 1% and 0% respectively.
In both of these cases the depletion of the fund occurs still earlier, in 2038 in Case 2 andin 2032 in Case 3.
No Alternative but to reduce Benefits
In order to maintain the pension fund until 2050 under these new economic assumptions,
we might first consider significantly increasing pension premiums, above the currently
scheduled increases2. For example, in Case 3) it would be necessary to set the upper
limit at 1.8 times the currently scheduled level (18.3%), using a 0.598%-point annual
increase from 2013 to reach 33.26% in 20403.
Figure 2 Scenarios for Pension Reform
2009 Actuarial Valuation
the Puclic -Pension Plan
Base line case

Alternative calcurations

Mechanicalcalculations

1)

Case 1Case 2

Case 3Rate of return

4.1%

1.5%

1.4%2)

1.4%

2)

1.4%

2)

Wage increase rate

2.5%

▲0.7％

2.5%

1.0%0%

Period for depletion of pension reserve
funds

depleted

Year 2060

Year 2038

Year 2032

AssumptionsNot3)

Year 2032

3)

Application of measures to prevent depletion ofreserve funds before 2050

Mechanicalcalculations
Alternative proposal 1) :Alternative proposal 2):

Case1

Case2

Case3

35.85%－24.51%33.26%

42%
reduction－21%
reduction

39%
reduction

Increase ininsurance
Reduction of5)benefits(Note)

1 Mechanical calculation 4) on Page 6 of materials related to the 2009 Actuarial Valuation of the Public Pension Plan (Published for the 15th
Meeting of the Pension Subcommittee of the Social Security Council on May 26, 2009), Ministry of Health, Labour and Welfare.
2 Average value since GPIF commenced operation of fund (2001-2011).
3 Each figure is based on estimates by the Ministry of Health, Labour and Welfare.
4 Insurance premiums in 2040.
5 Uniform reductions in benefits from fiscal 2013.

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Assuming that it is not possible to increase pension premiums above the currently fixed
level, it will be impossible to avoid reducing pension benefits. Under the conditions ofCase 2), this reduction would be 20%, and under the conditions of Case 3), a little lessthan 40%. It will be objected that reductions in pension benefits of this type will not beacceptable to pension recipients, but there is no alternative to these measures if we wish
to avoid the hard landing scenario, which would result in even higher reductions inbenefits.
Moving beyond “Silver Democracy”
As Japan advances further along the path of “silver democracy,” as indicated above, asituation in which the elderly wield significant political influence, the realization of areduction in pension benefits, including the benefits of current pension recipients, willbe criticized as unrealistic. However, the current pension system, which is heavily
reliant on loans from future generations, is not only an unfair system that passes themajority of the burden on to our children’s and grandchildren’s generations, but is also
an unstable system based on economic assumptions which do not correspond to reality.
Assuming that the current level of pension benefits is maintained throughout arecipient’s life, despite the fact that the benefits can be considered “high return” to theextent to which the burden is passed on to later generations, they are also “high-risk”
assets, with the potential for a significant reduction in benefits to result from a collapse
in the system.
If they were sufficiently aware of these facts, it is quite possible that the highly
risk-averse elderly, the current pension recipients, would accept a partial reduction in
their pension benefits in order to ensure that the benefits remained stable assets for theremainder of their lives. This possibility is supported by the behavior of elderly
households in selecting financial assets. In the analysis conducted for this research, therate of holding of risk assets such as stocks and bonds declined as the age of the head of
the household increased, indicating the strength of risk aversion among the elderly.
From this perspective, it is possible that elderly generations would accept a reduction in
pension benefits based on self-interest. This is to say that if pension benefits are
considered government-guaranteed assets, as is presently the case, the elderly willstrongly resist a one-sided imposition of reductions by the government. However, if it
becomes clear that in effect these assets are being transformed into non-performing
debts, a partial reduction in benefits, akin to a market operation to ensure the value ofthe remaining assets, would be more acceptable to the elderly as a rational choice.
However, comprehensive efforts to make the public aware of the systemic risk
associated with public pensions will be a major precondition for the realization of thispossibility. Under the current system, if the nation exits from a state of deflation and the5“consumer price indexation” mechanism goes into effect, a “macro-economic slide”
mechanism will also go into effect to reduce the value of pension benefits in real terms,
without the knowledge of their elderly recipients. However, the risk to the sustainabilityof the system can only increase to the extent that we remain committed to the idea of apension system which will be secure for 100 years and fail to respond using amechanism of this type.
Formulating a Schedule for Systemic Reforms
By contrast with the uniform pension benefits received by beneficiaries aged 65 andabove, medical and nursing benefits will not only increase in proportion with the agingof the baby boom generation, but the future state of finances of medical and nursing
care insurance will become increasingly severe due to factors including increases inpayments with advances in medical technologies. Rationalization of the healthinsurance and long-term care insurance expenses of the elderly and restriction of theburden on the public to within the scope of possible economic growth will be importantfactors in the realization of a sustainable system into the future. In order to enable this, anumber of reforms will be necessary, including: 1) The realization of an appropriate
allocation of roles for hospitals and clinics, for example through the introduction of afamily physician care system; 2) The rationalization of nursing care insurancebenefits; and 3) Clarification of the scope of coverage of health insurance.
The time is approaching when Japan’s current system, which transfers the burden ofpension and health insurance and long-term care insurance costs to later generations bymeans of unlimited issuance of government bonds, will be controlled by market
discipline. It is essential that we make the control of social security expenses to a level
which can be borne by the working generations our fundamental guiding principle, anddraw up a schedule towards the necessary systemic reforms as soon as possible.

Note1) Average annual values from 2001 to 2011 are 1.4% for rate of investment return and -0.7% for wage
increase rate.
2) A 0.354% point increase per year, with an upper limit of 18.3% in 2017.
3) If the amount of increase in medical and nursing care insurance is included, the burden significantly
exceeds the limit that could be borne by users and the proprietors of businesses.

NIRA Report
Reforming Japan’s Government Bond-financed Social Security Systemby Overcoming ”Silver Democracy”
The Japanese version of the full report: http://www.nira.or.jp/pdf/1204report.pdfⓒ 2013 National Institute for Research Advancement(NIRA)

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