In Japan, the once-popular Tax-Qualified Pension Plan (TQPP) is scheduled to be eliminated by March 31, 2012. Many companies have already taken action to deal with the necessary plan conversions, but there are still approximately 20,000 TQPPs left, including the pension plans of many multinational companies. As payments to defined contribution (DC) plans are limited in Japan, companies often incorporate a defined benefit (DB) element into the new plan design with associated requirements related to funding and reporting. Once companies have completed the plan conversion, other important decisions must be made to effectively manage cash flow and minimize the risks associated with the pension plan.

In this article, we explore the historical development of the Japanese system and provide insights into the decisions companies must now make in light of the introduction of a new funding regime.

The Japanese pension system

The state system

The public pension system in Japan has two layers. The first layer is a universal pension system that pays a fixed pension amount for practically everyone. The second layer is the Employee Pension Insurance (EPI). EPI system benefits are based on total career earnings and are reserved for salaried employees.

By 2030, pension payments will commence at age 65 for both systems and will target an income replacement ratio (based on a married couple where one spouse, typically the wife, does not work) of around 50%. Transition arrangements over the next 20 years allow progression from the previous entitlements of a 59% pension from age 60. There is also a maximum pensionable salary, which reduces the income replacement ratio for higher earners.

Employer pension provision

When the TQPP was introduced in 1962, employers could receive tax deductions on contributions in exchange for setting up externally funded pension plans. Almost all the participating companies received asset allocation advice from fund managers. Employee Pension Funds (EPFs) followed in 1966. EPF plans contract out a portion of EPI benefits under the Ministry of Health, Labor and Welfare’s (MHLW’s) funding requirement regulations. EPF plans must provide lifetime pensions. On the other hand, TQPPs fall under the authority of the National Tax Agency, are not subject to such funding regulations and are often seen as lump sum plans. Many people receive termination lump sums, as the lump sum is more attractive for tax reasons than is the fixed annuity (not a lifetime pension) typically offered.

With the bursting of the bubble economy in the 1990s, major issues surfaced. Many companies collapsed and could not pay the accrued benefits of their employees in full, because their TQPP plans were poorly funded. At the same time, it was increasingly difficult for larger companies with EPFs to maintain sufficient assets to cover the EPI contracted-out benefits. Consequently, EPF sponsors put in a plea to return the EPI contracted-out portion back to the government.

Concurrent with these events, Japan was experiencing a major transition to a new pension accounting system (effective April 2000). The funding shortfall, which had previously been booked off the balance sheet, now has a big impact on corporate financial statements.

It was against this background that two new types of pension plans were introduced: DC plans, in October 2001, and new DB plans, in April 2002. The DC plans helped to solve the issues raised by the new accounting standards. There was no need for the employer to recognize any liability on the balance sheet.

The new DB plans were established as successors to TQPPs and EPFs. Since the government decided to allow employers to return their EPI contracted-out portion back to the state – a process known as Daiko Henjo – there was a need to set up a new type of DB plan without the contracted-out portion.

Furthermore, the government needed to review the TQPP arrangements in order to protect participants’ accrued benefits. Consequently, new DB plans emerged with no contracted-out portion but instead with strict funding requirements similar to those of EPF plans. No new TQPPs are allowed and existing TQPP plans have to be terminated or transferred to other vehicles, such as a DC plan or a new DB plan, by March 2012.

Since April 2002, EPFs and new DB plans have also been allowed to use a cash balance design (with a more stable cost), based on keeping a “notional” account that is credited with contribution payments, and an annual market interest rate.  

Recent trends

From a risk perspective, sponsoring a pension plan is tantamount to running an insurance company as a subsidiary. The investment, interest rate and longevity risks are recognized as risks borne by the sponsoring company and, as in the US and the UK, there is a trend toward actively managing and reducing these risks.

The vast majority of large-sized companies decided to convert their EPF plans into new DB plans after undergoing the Daiko Henjo process. Currently, most of the existing EPF schemes are multiemployer schemes that are cosponsored by small- and medium-sized companies, and this includes many subsidiaries of multinational companies. The typical benefit level provided is rather low, and so if these EPF plans decide to carry out Daiko Henjo, the benefit level will become too small to maintain the plan itself. The only other option is to withdraw from the multiemployer EPF by paying an exit penalty.

The trend among Japanese subsidiaries of foreign multinationals that eliminate a TQPP is to replace it with a combination of both a DC plan and a new DB cash balance plan. While these companies would prefer to have only a DC plan, this would make it difficult to maintain a competitive level of benefits due to the relatively low legal contribution limits for DC plans (JPY 612,000 per annum per participant, if there is no funded DB plan, and JPY 306,000 per annum, if there is a funded DB plan).

Funding requirements for new DB plans

Under the new DB law, an annual review of the funded status of the plan is required. The review must focus on the following two standards:

• Whether the deficit is within an acceptable range (the going-concern standard)
  
• Whether the plan assets exceed the minimum funding liability (the dissolution standard)

Going-concern standard

Actuarial liability and funding liability

The actuarial liability under the going-concern standard is defined as the difference between the total liability obligation (including future accruals) and the present value of normal contributions. If the plan assets taken at market value (although some smoothing is allowed) are less than the actuarial liability, this funding shortfall must be amortized over a period of up to 20 years.

Another actuarial measurement used is the difference between the actuarial liability and the present value of special contributions (amortization contributions for the funding shortfall). The amount of the funding liability is seen as the expected level of plan assets. Therefore, each year during the annual funding review, the level of funding must be verified by comparing the value of the assets against the funding liability amount.

The plan sponsor is permitted to set the interest rate that is used in the funding calculations, but the rate must be approved by the pension actuary in charge of the pension plan. The maximum rate must be based on the expected investment return, and the floor rate must be based on the yield on the 10-year Japanese government bond. Approximately 55% of plan sponsors have adopted a rate in the 2.5% – 3.5% range, 35% of plan sponsors have adopted a rate of 3.5% and above (maximum 5.5%), while 10% have adopted a rate of less than 2.5%.

The plan sponsor can determine the threshold amount, or the amount of deficit that is tolerated. If the deficit exceeds the threshold, an amortization of total deficit must be scheduled. The threshold amount can be determined as a fixed percentage (maximum 15%) of the funding liability amount or of the present value of normal contributions for 20 years. Many plan sponsors take 15% of the funding liability.

Broadly speaking, there are two different methods of amortizing the shortfall: the straight-line method and the fixed-ratio method. Under the straight-line approach, a company would evenly amortize the shortfall over a period that it has chosen (between three years and 20 years). Under the fixed-ratio approach (or declining balance method), the company would amortize an amount equal to a certain percentage (between 15% and 50%) of the balance of the unamortized shortfall as of the preceding plan year-end.

Dissolution standard

The minimum funding liability (Saitei tsumitate kijungaku) is calculated as the present value of the minimum vested benefits (MVB – Saitei Hozen Kyufu ). The MVB for the pension beneficiaries and the deferred pensioners is simply the amount of the pension provided by the plan. The MVB for active participants is determined in such a way that the amount calculated is less than the accrued benefit amount, assuming the active participant is retired by the measurement date. Therefore, it can be said that the MVB is, as the name indicates, a minimum amount that must be protected. 

The interest rate used for funding calculation purposes based on the dissolution standard is determined by applying a coefficient of between 0.8 and 1.2 to an interest rate to be decided based on the yield on the 30-year Japanese government bond.

Funding standards

Basically, the plan assets must exceed the minimum funding liability amount. That said, there is a special provision that allows the funding level to be as low as 90% until March 31, 2012. If there is a funding shortfall, there are two approaches to solving the funding problem. The first method consists of applying a new contribution payment timetable in such a way that the shortfall is eliminated within a period of seven years (or 10 years, prior to March 31, 2012). The second method involves increasing the contribution level to the minimum level required, effective from the following plan year.

Funding status of new DB plans

On the going-concern standard, in 2009 new DB plans registered an average funding level of 70% against the actuarial liability, and the deficit against the funding liability was almost the same as the threshold. Therefore, it can be assumed that approximately half the companies sponsoring new DB plans were forced to consider paying a higher contribution.

The average funding level from the standpoint of the dissolution standard was 80%. Many companies experienced a funding level of under 90% and thus, it is assumed, had to face an increase in the contribution payment.

Moratorium on funding relief for new DB plans

Under the current law, if it was determined that the new DB plan was unable to fulfill the funding requirements based on the going-concern or dissolution standard at the annual review of the funded status as of March 31, 2009, the employer was required to reset its contribution rate by April 1, 2010.

Only the deficits exceeding the threshold acceptable amount will be subject to amortization. Employers can adopt this approach if they are required to increase contributions under the going-concern standard at the annual review of the funded status of their plans. If a regular revaluation is scheduled by March 31, 2012, all deficits will be amortized as required under the current funding rules.

Issues to consider

In conclusion, there are three issues that multinationals need to consider:

1) Termination of TQPP

Discussions on establishing a new pension plan should start as soon as possible.  About 20,000 TQPPs are still left in Japan, despite the fact that only two years remain before the deadline of March 2012. It typically takes at least one year to complete the plan conversion process and convert the TQPP to another vehicle. An alternative for multinationals is to simply convert the TQPP to a new DB plan, which would require minimal changes, but there are still requirements to be met under the new DB regulations. It is highly recommended that companies make a decision on this matter by mid-2010.

2) Plan governance

The funding requirements increase significantly after converting a TQPP to a new DB plan. However, there is also increased flexibility in determining the funding schedule. A company can determine the threshold amount for the going-concern standard; select the smoothing method for plan assets; apply the flexible method for the amortization of the funding shortfall; or choose from the two approaches to improving the funding level when the dissolution standard is not met, etc. As each decision will have a financial impact, a governance structure for the new DB plan should be established to minimize the risk of a sudden need to increase contributions. Before converting to a new DB plan, a company must first thoroughly understand Japanese funding rules, determine a funding policy and carefully monitor the plan’s funding status and any developing legislation.

We further note that the risk of trapped surplus is getting increasing attention from multinationals with plans in other jurisdictions – the risk being that a combination of increased contributions and good market returns could create a situation where the employer has contributed too much. This risk is quite acute in the Japanese context and needs to be given careful consideration in governance discussions.

3) Investment risk management

Under the new DB plans, the company is solely responsible for asset allocation, which should be determined by the nature of the pension liabilities and your company’s risk tolerance. In particular, if your new plan is a cash balance, you should bear in mind that the benefits from such plans are linked to market yields. Therefore, examining sensitivity with respect to interest rates for both pension liabilities and possible asset allocations is an important first step for all new DB plans. This could be achieved through an Asset Liability Management study.