Defined Contribution Plans; Are They Needed in Japan?
An article by Leslie John Lohmann, FSA
We believe that this issue is the result of an answer looking for a question. Ask any broker. He will tell you that the answer to Japan's economic problems is Defined Contribution (DC) plans. We feel we know why brokers want DC. For reasons we don't understand, those who recommend, draft and pass laws in Japan also seem to want DC.
Arriving the first time in Japan in July 1990, the actuarial culture shock was unexpected. I was to provide primarily FAS 87 valuations to subsidiaries of American firms that then (1990) needed to comply. There were communication problems (other than those related to my lack of language skills). There were surprises (other than my first earthquake).
But after nine years of providing retirement plan actuarial services in Japan, I have one remaining surprise: that Japanese do not recognize the superior private retirement plan system that they have. I am surprised that they don't recognize the strengths and build upon them. I'm surprised that no one seems to have enumerated the weaknesses and they are not being specifically addressed, while maintaining the overall system design.
SOME COMMON CHARACTERISTICS OF DEFINED CONTRIBUTION (DC) PLANS.
A general form of Defined Contribution (DC) plan for employees is an employer-sponsored plan where part of an employee's cash compensation is accumulated in an employer-sponsored investment account. Although known as "retirement plans," they only function as retirement plans insomuch as employee participants are not permitted to use the money they have accumulated until retirement. Often, part of the employee's pay is paid conditionally, requiring the employee to serve a specified number of years (there can be other requirements also) before the money, including investment income earned by that money, vests.
When a plan meets certain requirements, the employee will be permitted to exclude the amounts contributed to the account and the related investment income from current taxation. Employers typically get to deduct amounts paid regardless of whether the plan is "qualified" or not. Since the investment income belongs to the participants, it is not taxable income to the employer sponsor. Employees are permitted varying degrees of investment choice with their accumulations.
When an employee retires, the amount accumulated is paid. Any amounts not vested revert to the employer, perhaps creating a taxable event for the employer. Some plans limit disbursement choices but most provide a single lump sum to the employee which is taxable at the employee's top marginal rate unless the amount can be "rolled over" into another tax-favored vehicle.
Please see figure 1. Plan participants get the immediate value of the lump sum calculated at retirement, meaning that, like Japanese Defined Benefit (DB) plans, DC plans provide 100% of the lump sum benefit no matter how old the employee is at retirement and, thus, provide reasonably good portability of benefits.
DC plans shift risk from the employer to the employee when compared to DB plans. And, while the truth of the Risk/Return paradigm (footnote 1: Over the long term, higher investment risks lead to higher investment returns) holds even here, we believe that the employer is a position to properly evaluate those risks while most employees are not. Like a lottery, the risks are seldom known to the average employee until the results are in. Unlike a lottery, there are, over the long term, more winners than losers, but we feel the losers were not truly cognizant of the risks they were adopting when they made the decision.
Employer costs of DC plans are more certain than DB plans; neither uncertainty of investment performance nor the effects of future pay changes affect employer cost. While one might look to this certainty with a certain amount of affection, it should be realized that it is a certainty of higher costs over the life of the retirement plan. One way American employers reduce the impact of these costs is by shifting the costs of retirement to employees through the 401(k) DC plan that uses the matching principle.
DC plans provide benefits related to the entire career of an employee. They cannot provide benefits related to the employee's final standard of living. And, they never provide the amount considered optimum in the original retirement design. In the US, the problem has been dealt with by adding additional employer cost through a device known as a "floor plan." A floor plan is an additional DB plan that guarantees a minimum benefit in case the DC plan fails to deliver the originally designed benefits. Of course, this is at extra employer cost and administrative headache.
The fact that no plan participant ever gets the benefits designed or expected from the plan is a serious weakness of DC plans. The reason for this phenomenon is that the participant gets the market value of the investment account at retirement, nothing more, nothing less. If the "market" is doing well, he will get more than planned to the detriment of the owners of the entity. If the market is "down," he will get less than planned, to his own detriment. In the latter situation, it is important to remember that the sponsor paid more than needed for what turned out to be the employee's inadequate benefit. The probability of an exact match is literally zero!
Finally, DC plans encourage saving over consumption. In a nation such as the United States, where savings rates are notoriously low compared to Japan, DC plans have had an important influence on increasing the rate of saving among employees. In Japan, where savings rates are already recognized as being high, encouraging additional savings can only lead to reduced consumption and related economic activity.
STRENGTHS OF THE JAPANESE PRIVATE RETIREMENT SYSTEM.
We see the following advantages of Japan's unique approach to defined benefit (DB) plans:
(i) Good design and appropriate cost
(ii) Reasonable portability
(iii) Little participant investment risk
(iv) Little discrimination in favor of the highly paid
Benefit Design and Cost . When designing retirement plans, an actuarial consultant emphasizes certain principles to the plan sponsor. Two of them are that the plan should provide the right benefits to the right people at the right time and that the cost of those benefits should be appropriate.
Japan's basic private system actually automatically provides for both of the "basic" design principles. Plan design is typically quite simple; a lump sum paid at retirement based on final pay and service. "Insured" plans (both those provided by Insurance companies and those provided by certain Trust Banks) also provide annuities, usually nominally actuarially equivalent to the lump sum, but the Japanese tax system so favors lump sum retirement benefits that retiring employees usually take the lump sum, even when there is a chance for arbitrage and/or anti-selection favoring the selection of the annuity. "Book Reserve System" plans can provide only lump sums, but, like the lump sum delivered by the externally funded plan, it is tax-favored. Both funding methods are designed to deliver the "right" benefit at retirement, since it is the one intended by the plan; it is neither larger nor smaller.
The typical Japanese retirement plan is a true final pay plan. DC plans are based on career earnings. This has little impact on the average worker. It can have an enormous impact on the worker who experiences higher than average increases in earnings over the last few working years. A final average plan will reflect this change, a career average plan won't.
It has often been said that a retirement plan should provide a level of benefits that will permit a career employee to live in retirement at about the same standard of living enjoyed while working just prior to retirement. Final average plans are capable of achieving that goal for all career employees. Career average plans achieve the goal only for average employees. Career average plans actually provide too much for the employee that turns out to be a less than average performer in his last years. They provide too little for the employee that turns in star performance in the last years.
There are two serious differences between DB and DC plans that affect sponsor costs and participant benefits: (i) individuals can tolerate less risk and have shorter investment horizons than sponsors and (ii) no plan participant ever gets the exact amount anticipated from a DC plan. These two differences are the source of my most immediate concern about DC being introduced.
It is widely accepted that higher risks lead to greater returns in an investment portfolio. Longer investment horizons also lead to greater returns due to the ability of a portfolio to withstand longer periods of poor performance, and, thus being able to accept higher risks. Assuming that a DC contribution plan is designed to produce similar (theoretically) results to the DB plan it is replacing, costs will be dramatically higher. In the U.S., we have often seen 200 basis points used as an approximation of the difference. While we have not studied the situation in Japan, we suspect that the difference is greater and that the impact, given the historically low "safe" returns in Japan, magnified.
Sponsors will have to pay this difference, assuming that benefits are designed to be unchanged from current levels.
One might question the assertion that the price is "right." The investment climate in Japan has been so bad for the past several years that retirement plan costs have been escalating. But, unlike the US where regulatory burden is seen as a major part of the high cost of Defined Benefit (DB) plans, everyone in Japan is subject to the same economic environment. While much of the rest of Japan is over-regulated (hence the investment climate), Japanese retirement plans are largely left alone.
Therefore, a plan sponsor is paying only for the benefits promised plus a small incremental charge for administration (sometimes not even incremental with a Book Reserve plan) and another for asset taxes (not applicable at all to Book Reserve plans). The available investment earnings serve to lower out-of-pocket. While external retirement funds seldom attract the same rate of return as funds invested in the business, it is often felt that the additional cost represented by lost earnings or increased borrowing costs is appropriate for the additional perceived security of an external plan. Of course, the hidden investment rate of return for a Book Reserve plan is the company's ROI (Return On Investment).
These funding methods (Insured and Book Reserve System plans) combined with the typical design, keep investment transaction costs relatively low (ignoring the high fees charged for trading by brokers). Companies, especially the insurers and trust banks, have kept two important principles in investing the funds in their care; (i) "Dollar Cost Average," as opposed to "Market-timing," purchases and (ii) "Buy and Hold." Anyone who has been "buying Japan" for the past six years will find they have bought a bargain after the turn of the century. Another investment principle comes to mind; "Buy low and sell high."
Another area that reduces administrative costs in Japan is the usual payment of benefits in lump sum form. The North American practice of keeping track of small amounts for former employees and paying annuities to many retirees leads to higher administrative costs. Administrative costs for Japanese DB plans are nearly identical to those for a DC plan, assuming that the cost of individual allocation and record keeping demanded of DC plans is roughly equal to the costs of valuation for a DB plan.
We feel that, after removing the effect of the investment climate in Japan, the cost of Japanese retirement plans is appropriate.
Portability . Part of the concept of the "right amount" includes a need for portability; an employee should have a reasonable chance of replacing lost benefits when retirement occurs mid-career.
What is a "portable benefit?" In a perfect world, a new employer would permit a new employee to transfer all of his previously accumulated retirement assets into the new employer's pension system. At retirement, the employee would receive a benefit based upon total service from the first employer with no diminution for having worked elsewhere. Social plans achieve this result to a degree by insulating benefits from the source of employment. But they often fail to provide an appropriate benefit since the retirement benefit is typically based on the employee's career earnings rather than his final earnings (a "career average plan").
Since many private plans are "final average" plans, the new employer is going to experience additional costs representing the benefits earned for pre-employer service but not purchased by the transferred funds. Few "new" employers would agree to such an approach since they do not feel obligated for benefits based on their plan but for service with a prior employer.
Further, the "old" employer, the one being left, shouldn't like to have to provide additional assets to a departing employee just because the new employer's plan is more generous or because the employee has managed to get a significant increase in earnings.
So, realistic portability is represented by the employee receiving at retirement an amount of money that could buy the anticipated future benefit from the former (the"old") employer when retiring at the age limit of the new employer. Japan's current system as typically applied achieves this result. Maybe better.
Typically, the Japanese employee's lump sum benefit is calculated without regard to age at actual retirement. There are no "early retirement penalties." The entire value is available to invest or, if there were a market in Japan, buy an individual annuity to start immediately or to start at a later date. Japanese plans are mathematically "front-loaded" based on how the "deferred annuity" is accrued over the employee's service lifetime.
Unlike Japan, North American DB plans have failed miserably at providing a reasonable degree of portability. The failure arises from two aspects of calculating the terminating employee's benefit; the amount is calculated as the present value of an annuity whose first payment is deferred and the present value typically includes a discount for survivorship. These result in the increasing concave curve of termination values associated with North American plans as shown by the lower line in figure 1.
Figure 1 illustrates the portion of the lump sum value that a retiring participant can get at each possible age of retirement compared to 100% of the lump sum value available at retirement at the age limit with the same amount of service. There are two lines. The higher one shows the proportion that a Japanese employee would get from a typical plan - always 100%. The lower one shows what an American employee might get. We have arbitrarily set both plans to a normal retirement age of 65 to ease the comparison, but, as can easily be seen, it doesn't make any difference to the Japanese employee since 100% is always available.
While Japanese plans were not specifically designed to be portable, in fact, they are. It is a consequence of benefit designs that ignored early severance due to the Japanese practice of "lifetime employment." Since few employees ever retired before the age limit, it was an unnecessary additional administrative burden to provide different benefits based upon the age at retirement.
As is shown, the Japanese employee gets a significant multiple of what his American counterpart does, magnified in the case of retirement at an early age. Taxes multiply the effect, since, if the American does not deposit his pittance into a qualified rollover instrument, he is generally taxed at his top marginal tax rate on the entire amount in the year of retirement. It is virtually impossible for the American employee to successfully replace lost benefits with the amount he is provided at early retirement.
Japanese plans further enhance the real intent of portability by distinguishing between voluntary and involuntary "retirement." The voluntarily retiring employee has a chance to consider the benefits of his new opportunities. The involuntary one often does not. America treats all departing employees the same way, reducing benefits even when the company is responsible for the departure and the employee may be faced with a significant period of unemployment. These periods put future retirement benefits at risk, since the former employee may need the money for current living costs.
Investment Risk . Japanese employees are able to rely on getting the benefits they have been promised by the plan. They are able to plan. They can comfortably make decisions about retirement knowing that the amount they calculated will be available to them when they ask for it. Voluntary retirement is a big decision. Even Americans examine the pros and cons well in advance of making a decision to retire. A defined benefit assures the participant that the amount of money expected is the amount of money paid.