Funding ratios for Japanese pension funds declined to 82% in 2010, a level that represents a slight deterioration from the 84% average reported in 2009 and a much more significant decline from the robust 101% funding ratios reported by plan sponsors in 2008.
The results of Greenwich Associates’ 2010 Japanese Investment Management Study suggest that for many individual pension funds, the funding crisis is actually much worse than suggested by these average levels: 70% of Japanese pension funds are funded below 90% and one-third of Japanese pension funds report funding levels of 75% or lower.
“In general, Japanese plan sponsors do not intend to try to close these funding gaps by boosting investment returns,” said Greenwich Associates consultant Taeko Sumiyoshi. “To the contrary, sponsors of Japanese defined benefit pension plans are planning aggressive actions to reduce risk levels within their investment portfolios. Japanese pension funds that say they plan to alter their investment policies over the next 12 months are more likely to say they are looking to reduce risk than to report they are changing their policies to seek out higher returns.”
Accepting a New Reality
Apparently, plan sponsors have decided to accept the reality of elevated contribution requirements as an acceptable price for reduced volatility and lower levels of risk. In making that calculation, Japanese plan sponsors are moving in step with their counterparts in Europe and the US. In both of these markets, corporate pension funds have taken dramatic steps to ‘de-risk’ by shifting assets from equities to fixed income and implementing asset-liability matching programmes and liability-driven investment programmes. There is one major difference between the pension industry in western nations and that in Japan, however: In Europe and the US, many of the plan sponsors now shedding risk have closed their funds to new employees, placing some cap on future liabilities. In the UK, for example, 79% of corporate UK defined benefit plans are now closed to new employees.
Even in countries in which most defined benefit plans have been closed to new employees, the de-risking of pension funds represents a decision on the part of plan sponsors to commit themselves to higher future contribution levels and the possibility of future reductions in benefits. “Without the prospect of relatively high levels of investment return, the only way for plan sponsors to close funding gaps and cover long term pension obligations will be through cash contributions,” said Greenwich Associates consultant Dev Clifford. “This is especially true in Japan, where the closing of defined benefit plans is generally not seen as an option.”
Allocations, Investment Returns and a Historic Funding Gap
A comparison of Japanese pension funds’ actuarial assumptions with reported rate of return expectations reveals the largest funding gap ever recorded in a decade of Greenwich Associates’ investment management research in Japan. Pension funds expect average annual returns of 2.4% on plan assets over the next five years. Subtracting this expected return from funds’ reported actuarial assumption of 4.3% leaves a funding gap of 1.87%.
Japanese institutions reduced expected rates of return on domestic equities to 6.3% in 2010 from 7.0% in 2009, while increasing return expectations on international equities to 7.7% from 7.4%. Return expectations on fixed income were essentially unchanged from year to year. Overall, equities make up 34.2% of corporate pension fund assets and 19% of public pension fund assets. Allocations to fixed income average 46.3% among corporate funds and 76.3% among public funds. Domestic bond allocations decreased slightly among public funds and were unchanged among corporate funds. Japanese corporate funds reported a decrease in hedge fund allocations to 5.3% of total assets from 5.6% and an increase in real estate allocations to 9.6% from 9.4%. Cash allocations increased to 1.9% of assets from 1.1% among public funds, while dropping to 1.6% from 2.1% among corporate funds.
De-risking Pension Portfolios
Looking out over a longer horizon, Japanese institutions leave little doubt that they intend to adjust portfolio allocations to reduce volatility and risk. This de-risking process is taking two main forms: institutions are reducing equity exposures and shifting assets out of actively managed strategies and into passive.
The number of Japanese institutions planning to reduce target allocations to active domestic equities is more than seven times larger than the number planning to increase. In every fixed-income strategy the number of institutions planning to increase allocations tops the number planning reductions. Two other assets appear poised for institutional inflows: hedge funds and real estate – both of which are used by Japanese institutions for consistent, low volatility returns.
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