Fidelity Investment's (Japan) Haruka Urata published “Defined Contribution Plan Reform: Proposal for Japan” this summer. Mr. Urata's expertise derives from more than 25 years in the defined contribution (DC) market.
IJ here provides an introduction and chapter summaries in English. For the full version with appendix, follow the link at the end of this article.
Defined Contribution Plan Reform
Proposal for Japan
- Enhancing private pension systems -
Fidelity Investment (Japan) Limited
Head of DC Proposition & Thought Leadership
In 2019, Japanese citizens began to demonstrate an understanding that they would be responsible for ensuring that they would have enough savings to be able to retire. A growing anxiety regarding future sufficiency of funds had slowly begun to drive this shift in sentiment. However, from the government's point of view, this shift resulted from society generally moving in the right direction, without the aid of new tax breaks or financial stimulus.
Unfortunately, despite this shift in awareness, the system and mechanism necessary to save funds for retirement is underdeveloped in Japan. The limit on contributions to defined contribution pension plans is 1/10th the size that it is in the United States. Additionally, there are many similar but smaller plan types that serve same purpose, including as Tsumitate NISA and Zaikei Nenkin, which are difficult to understand for the average person. To offer a simple metaphor, consider a pitcher who has an incredible variety of pitches, but there is currently no catcher available because there are too many candidates for the position and no individual seems to stand out.
Indeed, as overseas research on private pensions is progressing behind the scenes to improve the retirement savings system, full-scale discussions on the system should begin this summer. 2020 will be an important year for us to discuss the ideal private pension system for Japan from the perspective of the people. The people have the will, determination and basic knowledge to start talking about this topic and so the time is ripe. This paper aims to facilitate and contribute to that important discussion.
Some background information on defined contribution (DC) plans in Japan:
- Japanese DC plans became available in October 2001 under the Defined Contribution Plan Act.
- There are two types of DC plans in Japan -- employer-sponsored and individual.
- Originally, in an employer-sponsored plan, only the employer could make contributions (no employee contributions were permitted). In the individual DC plan, only individuals could make contributions. However, this distinction has become vague over the years.
- DC contribution limits are restrictive and equal to tax beneficial limit, i.e. no after-tax contribution limits are allowed. This has not changed at all although there have been many minor revisions to the system.
Private pension is the key to relieving people's anxiety about their old age
In a society where birthrate is declining and the population is aging, an increasing number of people are arguing that the current pay-as-you-go public pension system alone is insufficient for preparing for retirement. It is also a challenge to incorporate the previously proposed accumulation method into the public pension system. Why? Because the current working generation will experience difficulty bearing both the pay-as-you-go system and the accumulation system.
The sustainability of Japan's public pension system is ensured through fiscal adjustment based on the Japanese Macroeconomic Slide¹. However, if the level of benefits is constrained by the macroeconomic slide, there will be a shortfall. While social welfare and public assistance systems are intended to be maintained, if there is a portion that cannot be covered by the public pension system, this shortfall must be covered by the private pension system.
Private pensions are not compulsory like public pensions, but instead are a bit random and autonomous. However, if individuals begin to believe that the solution to the shortfall is through private pension systems, then they are by nature more inclined to learn about what they need to prepare for their own old age at some stage in their life. Likewise, they will also be more driven to take actions in order to “help oneself.” While this report will touch upon the need of retirement/investment education in Chapter 6, the main theme of our discussion focuses on building/improving systems for retirement.
At present, Japan is not well equipped for private pensions. There are some available, but none of them are widely used, and the large variety of them, to be completely honest, confuses the public. The ones that are best known are iDeCo (individual-type defined contribution plan) and Tsumitate NISA, both of which have low contribution limits and unique sets of rules. This makes it difficult to use these systems, and as a result, supply-side financial institutions cannot make a profit by offering them. Therefore, these industries do not grow, which also associated with the lack of education on asset formation.
Currently, few life insurance companies are actively selling individual annuity products due to the impact of low interest rates. Products that guarantee a certain yield (in other words, pension payments) are risky for insurers.
They are also reluctant to sell these products because they offer a level of return that doesn't make sense to guarantee. Most of the products on sale are in sets with death benefits or Tontine-type pension products that benefit from long life. As a result, these days, individual annuity products do not function as a vehicle of retirement funds.
|¹||“Macroeconomic Slide” is terminology adopted by the Japanese government. To offer a short explanation on what this is, social security pension benefits (public pension benefits) in many countries increase as CPI and/or wages increase in order to maintain purchasing power. However, in 2004, Japan decided against increasing benefits 100% in line with price/wage increases and instead chose less than 100% depending on macroeconomic factors. In this sense the Japanese government would be able to manage the costs of the system to be more sustainable by adjusting the “Macroeconomic Slide.”|
Corporate pension plans are different from individual pension plans
Previously, I used the term “private pension,” but this word must be handled with caution. The term private pension is important only in the sense that it is not a public pension. It is important to understand that corporate pension plans (occupational pensions) and individual pensions are quite different in nature and therefore not interchangeable.
Corporate pension plans and individual pension plans have different financial sources. This is a crucial difference. The direct objectives (aside from the ultimate goal of both) differ accordingly. Employers introduce and maintain corporate pension plans as a means of implementing their own HR and financial strategies. On the other hand, the purpose of the individual pension plan is to prepare for the retirement of the individual and/or his/her family. Knowing this, it is important to keep in mind that companies and individuals are separate economic entities and distinct decision makers.
What kind of corporate pension plans will companies adopt? This important HR strategy governs the cycle of how people are attracted, retained, and in some cases released. It is also deeply related to the company's cash management strategy and its accounting of debt and cost management. These management strategies allow for companies to compete domestically and internationally and survive far into the future.
On the other hand, the act of an individual preparing for his or her old age is a very personal but irreplaceable act that the individual performs for himself/herself or his /her family.
Therefore, rather than lumping them all together as private pensions, it is necessary to consider corporate pensions from the perspective of maintaining the flexibility and competitiveness of corporate economic activities, and individual pensions from the perspective of social policy, including retirement preparation and consideration of income disparities.
The contribution limit is not equal to the tax benefit limit
The argument that both corporate and individual pension plans should be treated as private pension plans seems to have begun with the subject of tax breaks. However, I think it would be better to begin from a different perspective. In Japan, for example, it is said that "contribution limits for defined contribution pension plan = the tax benefit limit."
But from a global viewpoint, this is by no means a standard rule. As will be discussed later, in countries with well-established schemes, limits on contributions and benefits are managed separately from tax breaks.
If taxes are the initial and primary driver of these discussions, the system will only remain the patchwork that we see today. At this stage, it is advisable to set aside the subject taxes for now and instead to consider the true nature of the system from the perspective of social security and industrial policy. After considering these two key inputs, if we fold in the perspective of tax policy to try to achieve overall harmony within a proposed system, we may find make some headway.
There is a learning opportunity in observing overseas cases
Observing the systems utilized by other nations can give us a good bellwether in order to judge and improve our own system. With this, we will seek to introduce some of the best examples globally. Instead of saying "This is Japan. Japan has its own unique circumstances," it is important to incorporate knowledge gained from overseas cases and decide whether it is an appropriate fit for Japan.
Considering all of this background, it is time to begin our main discussion, focused on defined contribution plans (hereinafter referred to as "DC" as appropriate).
To begin, Chapter I examines the issues with the DC system in Japan from the perspective
of business owners individuals, and vendors and investment managers. Key problems
include "low contribution limits", "benefit reasons " and "incentive design for self help".
Setting the DB + DC Common Frame
The Japanese government is seeking to introduce the concept of a DB + DC Common Limit
as an approach to solving for the issue of the low DC contribution limit. Chapter II introduces
the situation in the U.K.. In order to introduce the combined limit in Japan, it is necessary to
relax current extensive employee consent requirements for reducing DB benefits.
Contribution Limit ≠ Tax Benefit Limit
While concerns over a drop in tax revenue have been a stumbling block to raising the
contribution ceiling, the proposal removes the stereotype that "Contribution Limit = Tax
Preference Limit" and proposes aft er tax contributions. Examples from the United Kingdom,
the United States, Australia, and other countries are introduced to explore effective tax
Separation of Participant and Employer Contributions
The DC system in Japan is not easy to use because the same rules are applied to company
sponsored DC plans and individuals DC plans. This chapter explains that problems can be
solved by applying different rules such as contribution limits and benefit reasons according to
contributors of premiums.
The Issue of Retirement Income Taxation
The retirement income tax system which is the most favorable taxation system in Japan is
applied at the time of receipt of lump sum payments, and very few people actually pay taxes
on benefits. This is an obstacle to further raising the contribution limit. It also hinders job
mobility as the tax system favors long time workers. Chapter V examines the taxation system
at the time of contribution, investment, and benefit payment.
Means of Incentivising Self-Help Efforts
The income deduction system, an incentive for contributions, unfortunately does not benefit
low income earners. First, it does not appeal to Japanese citizens as they are not all that aware
of their income tax payments as few people file tax returns. As a mechanism to supplement
this, Chapter VI proposes a matching contribution system by the government or employers similar to that which has been introduced in other countries.
My proposals are summarized as follows.
|1.||Eliminate the distinction between corporate-type DC and individual DC. Instead, define the contribution limits, benefit reasons, and taxation based on who make contributors (employers and individuals).|
|2.||Expanding tax breaks is the best option. However, if it is difficult to do so, then the maximum amount of contribution and the maximum amount of tax breaks should be set separately and, if necessary, allow after-tax contributions.|
|3.||The biggest advantage of defined contribution pension plans is that they are easy to understand. Introduce uniform limits that everyone can remember, an administration system that does not incur social costs, and easy-to-understand incentives.|
These are illustrated as follows.
2020 marks 20 years for DC in Japan. In the case of humans, 20 years represents coming of age. However, this is not the case for DC plans today.
The former Ministry of Labor was one of the first administrative agencies to consider the
introduction of DC plans. Since the Zaikei Nenkin (asset-building pension system) under its jurisdiction is similar to the 401 (k) plan in the U.S., the idea was to develop it in this way. The study was conducted in 1997 and I participated in the study as a person with actual experience in U.S. 401 (k) plans. The NLI Research Institute compiled the results in the "Report of the Study Group on the Management of Worker Contribution Pension Systems" in March of the following year. However, it was considered difficult to obtain tax benefits such as the 401 (k) plan in the era when the preferential tax system for savings had been abolished, and the plan was aborted.
Concrete work on DC legislation started in December 1998 when the Liberal Democratic Party's Tax Reform Outline sought "to take tax measures if defined contribution pension plans are to be realized". In the following year deliberations began at so-called "four-ministry" conferences between the Ministry of Health and Welfare, the Ministry of Labor, the Ministry of Finance, and the Ministry of International Trade and Industry (All names at that time).
At that time, the need was to control retirement benefit obligations by the DB with the introduction of the new corporate accounting system in 2000, as mentioned above. The argument for the establishment of a system to support the creation of assets in old age through self-help efforts has not yet matured, and the time has come too soon.
20 years have passed since then, however, and self-help efforts have become a keyword, and people have become more aware of how to prepare for retirement. I think it is time to explore the approach of the former Ministry of Labor.
It is highly likely that the "equal pay for equal work" paradigm which was applied from April 2020 will eventually evolve to prohibit unreasonable discrimination in retirement benefits. At present, the eligibility of DB and DC are mostly limited to regular employees. If this is to be extended to non-regular employees, what form will it take? Is it a "fairness of eligibility for membership" that allows anyone to join regardless of whether employment is regular or irregular, or is it going beyond that to "level of fairness" such as "same contribution for the same labor"? It will depend on future discussions. The taboo would be tougher regulations that would make business owners think, "if that's the rule, we'll abolish retirement benefits."
The system must continue to be upgraded in accordance with the development of people's consciousness, technology, and social and economic changes. We hope that discussions on reforming corporate and individual pension systems will be held in a way that is acceptable to everyone.