Investment risk-taking and benefit adequacy under automatic balancing mechanism in the Japanese public pension system

Abstract

Abstract The automatic balancing mechanism introduced in 2004 aims to re-establish the financial equilibrium of the Japanese public pension systems. The non-linear functions for benefits embedded in the automatic balancing mechanism make it challenging to analyse the impact of market fluctuations on the adequacy of benefits and the sustainability of the pension system. Using a stochastic simulation model applied to the government’s public pension verification programmes, the risk of benefit levels and financial stability according to risk-taking in pension reserve funds for the Japanese public pension system is investigated. The Japanese public pension system is characterised by a pay-as-you-go system with substantial reserve funds. Benefit adequacy is measured by the replacement rate and financial sustainability by the reserve-to-expenditure ratio. The results show that for a high level of risk-taking in the reserve fund, the risk of benefits increases because the automatic balancing mechanism reduces benefits until the pension system recovers solvency. In addition, the risk of reserve funds increases because of the possibility of sizeable negative investment returns. In contrast, when risk-taking is low, the benefit level is locked in at a low level because investment returns are insufficient. Therefore, moderate risk-taking of reserve funds should be adequate.