2. Longevity and Mortality Risk Markets

Through a variety of structures including swaps, indices, bond structures, and reinsurance, institutions can offset their exposure to any issues related to demographics. The following lists further explain such issues. Figure 2.1 illustrates how longevity risk impacts net returns for institutions exposed to either longevity or mortality risk. For example, an annuity provider loses money as its customers live longer than expected. Inversely, a life insurance company would benefit from longer living customers as it would mean more premium in flows over time.

Organizations Exposed to Longevity Risk

• Defined benefit (DB) pensions: A DB pension plan uses a formula based on an employee’s age, tenure, and income to create a formula for providing a prescheduled monthly income to retired employees until death. These plans use actuarial analysis to underwrite the scheme because the longer a retiree lives, the more payments the corporation must make to him. Social security in many regards is a DB program. These plans, which used to be commonly offered by corporations, are now on the brink of extinction due to longer-living retirees and large unfunded obligations that will create a massive drag on profit. According to actuarial firm Watson Wyatt, in 1985 89% of Fortune 100 companies had DB pension programs. By 2007, the number of such programs fell to just 28%. Globally, roughly $25 trillion of longevity risk is held by defined pension programs.

• Annuity providers: A life annuity is a contract between a purchaser and an annuity provider (typically a life insurance company) that provides monthly lifetime payments in exchange for an upfront cost. For example, a 65-year-old would make an upfront payment to Acme Insurance Corp. and in return would receive some nominal amount every year for the rest of her life. The longer the senior lives, the more payments the annuity provider must make to her. So if she surpasses the estimated life expectancy, Acme’s returns on capital would decrease and possibly become a loss.

Figure 2.1. Longevity mortality risk

• Life settlement investors: A life settlement is the sale of a life insurance policy from a senior older than 70 to a third-party investor. The longer the senior lives, the more premium payments the investor must make to the insurance carrier, which decreases the return on investment.

• Reverse mortgage lenders: Similar to a life settlement, a reverse mortgage uses life expectancy and real estate value projections (not typical FICO scores) to underwrite loans to seniors age 65 and over collateralized by their homes. Unlike traditional loans, these loans are not repaid until the senior dies or moves out of the home. One common reverse mortgage format is to provide monthly income to the senior for the extent of the loan. This means that the longer the senior (borrower) lives, the more payments must be made.

Organizations Exposed to Mortality Risk

• Life insurance companies: Life insurance companies generate profits by investing monthly premiums over a long period of time and, through “the law of large numbers,” paying a lesser number of claims. A couple may purchase life insurance at age 35 when they have young children and then maintain their whole-life policies for 30 years. At that point their children are adults, and they no longer see a need for the policies, so they let them lapse. The carrier in this scenario would collect 30 years of premiums and have to offer only a small amount to the seniors when they surrender the policies. With lapse ratios above 90%, the carrier relies on these long-term cash flows to pay any claims. Therefore, if an unforeseen outbreak of a virus killed 2% of their customers, a spike in claims would need to be paid out, and less lifetime cash flow would be received.

• Health insurance companies: Similar to a life insurance company, a health insurance company would be severely negatively affected if a virus broke out, because carriers would have to pay for a large increase in medical treatments.

• Pharmaceutical companies: Drug companies generate a substantial amount of profit from older and elderly individuals. A lifetime of illness is the golden goose in the pharmaceutical industry. If a large number of their customers were to die unexpectedly, that could mean a huge drop in company revenue.

• Municipalities: Municipalities with a larger number of older residents (pick any town in Florida) rely on tax income from a group that at some point will all die around the same time. This would mean growing expenditures and possibly a sudden and significant drop in tax receipts.

• Third-party investors: Hedge fund or other investors may have a view that longevity or mortality is underpriced or overpriced and therefore make investments to generate yield uncorrelated to other markets. This is similar to players in the credit default swap (CDS) markets, who need not actually be exposed to default risk to purchase or protection.

• Products: Investors in these risks, whether for hedge purposes or not, have a number of different vehicles in which to access the market.

Longevity swaps are one way to hedge longevity risk, or merely invest in it. Similar to any other type of swap contract (credit default or interest rate), fixed and floating cash flows are exchanged at predetermined dates. In a standard interest rate swap, the counterparty accepts a floating rate and makes a fixed one to edge against any fluctuations in interest rates. In a credit default swap, a protection buyer would pay a fixed amount—say, 125 basis points—annually to receive $10 million of credit protection on some reference company.

In a longevity swap, fixed and floating cash flows are exchanged based not on interest rates or default risk but on life expectancy. XYZ Pension Fund and ABC Investment Bank may identify a specific cohort by which to analyze their expected mortality probability. Suppose that, out of a group of 5,000 seniors above the age of 65, .5% matures in year 1, 1.5% in year 2, 3% in year 3, and so on. The pension fund would then pay some fixed coupon to the investment bank based on these expected mortality probabilities, and the investment bank would pay the pension fund based on actual mortality probabilities. Throughout the duration of the swaps contract, each counterparty may also be required to post collateral based on actual and expected mortalities quarterly or annually.

Pension funds have historically looked at freezing their pension plans or turning to pension buyout schemes, whereby a third party assumes the assets and liabilities of a pension program under the Employee Retirement Income Security Act of 1974. ERISA governs company-run pension plans, establishes a set of standards and protocols, and requires that the assets be invested with “care, skill, prudence, and diligence.” Due to large pension deficits incurred from the credit crisis, this is an unattractive proposition to buyout firms. This has further bolstered the longevity swaps business, although it should be noted that some investors view longevity swaps as a synthetic exposure to pension buyouts.

The first such longevity swap deal was transacted between Babcock International in the UK and Credit Suisse in 2009. The deal was written to limit Babcock’s Davenport Royal Dockyard defined benefit liabilities to roughly $482 million. The firm plans to insure an addition $750 million. In this structure, the pension scheme will make fixed monthly payments to Credit Suisse in exchange for mortality-contingent payments from a pool of 4,500 retirees.

Steven Dicker, senior consultant at Watson Wyatt, which acted as lead adviser, said: “This flagship deal heralds the launch of a new market in longevity risk. Longevity swaps have been talked about for years but, until now, there was no precedent of a satisfactory contract being drawn up. By demonstrating the technical obstacles can be overcome, a dockyard better known for supporting the Royal Navy’s battleships and submarines has boosted the armory of trustees and employers who want to reduce pension risks.”

Another major deal was closed between Deutsche Bank’s Abbey Life subsidiary and BMW in 2010. BMW purchased roughly $4.8 billion worth of longevity insurance from Deutsche Bank in February 2010, which was the forth such deal in two years. This landmark deal also contributed to the $11 billion of longevity protection written at the time, which was double the value of traditional pension buyouts.

Longevity bonds (see Figure 2.2) offer yet another way to participate in the longevity markets. These bonds, issued by a reinsurance company or investment bank, make a floating payment based on the survival of a specific population cohort. The coupon is set to the number of surviving individuals in that cohort in any given year. For example, a bond issued on January 1, 2011 may offer an 8% coupon based on a cohort of 1,000 individuals age 65, living in the UK, and composed of an equal mix of males and females. By January 1, 2016, this cohort has all turned 70, but roughly 500 have passed away in this five-year period. So the coupon would have declined annually in proportion to the number of deaths in the pool to its current level of 4%. The bond will continue to pay some coupon until all of the 1,000 reference individuals have passed away, which could take more than 15 years. Longevity bonds can be conceptualized as an inverse life annuity and therefore can act as a hedge for annuity providers.

Figure 2.2. Sample survival curve versus a bond coupon

Although the longevity market has experienced a tremendous amount of growth, clear barriers still exist. For example, longevity swaps, unlike other derivative transactions, are not yet governed through documents drafted from the International Swaps and Derivatives Association (ISDA), but the group is making an effort. Moreover, transparent and accurate longevity data is necessary because it is the underpinnings of all these transactions. In recent years, to provide further clarity on the market, several investment banks and reinsurance companies have started publishing life-linked indices:

• The Credit Suisse Longevity Index^sm: Released in December 2005, this is the first index designed to enable the structuring and settlement of longevity risk transfer instruments such as longevity swaps and longevity structured notes. The Index is intended for use by institutional and retail investors, insurance companies, reinsurance companies, providers of post-retirement benefits, and other longevity and mortality risk managers. By providing market participants with a single, transparent reference tool, Credit Suisse believes the Index, SubIndices, and underlying mortality rates will spur the development of a liquid, tradeable market in longevity risk. Credit Suisse and Milliman, the Index calculation agent, will release the CSLI annually. It is based on government mortality and population statistics, initially for the U.S. population.

• The LifeMetrics Index^sm: Launched by J.P. Morgan in March 2007, this is a toolkit for measuring and managing longevity and mortality risk, designed by J.P. Morgan for pension plans, sponsors, insurers, reinsurers, and investors. LifeMetrics enables these risks to be measured in a standardized manner, aggregated across different risk sources, and transferred to other parties. It also provides a means to evaluate the effectiveness of longevity/mortality hedging strategies and the size of residual risk. LifeMetrics advisors include Towers Watson and the Pensions Institute at Cass Business School.

• ICAP market derivatives that reference vivaDex^sm defined-pool longevity indices: Defined-pool longevity indices, first engineered by SwapsMarket^sm, reference pensions, annuities, life settlements, and other life-contingent assets or liabilities affected by alpha- and beta-longevity risk. The underlying pools can be an investor’s aggregation of life settlements or can be synthetic pools of insured grouped with similar characteristics, such as health impairment or cohort (age bracket). An example might be “75- to 77-year-old nonsmoking males, table 8-10 impairment.” Defined-pool swaps are collateralized with cash margin and expire every year for the expected life of the pool. When strung together, the swaps allow market participants to hedge exposures as short as two years and as long as 15 years, as well as enable yield-conversion strategies.¹

Goldman Sachs also created a longevity index known as the QxX index, but it was discontinued in 2010 due to minimal to nonexistent activity.

Longevity swaps and bonds are basically forms of reinsurance designed to protect against the very slow-moving economic risk of longer-living retirees. Extreme mortality bonds (also called XXX bonds) protect against random, completely unforeseen spikes in human mortality. Unlike longevity link instruments, mortality structures are not focused on simply elderly individuals, but on the broader population. Similar to the structure of a typical natural catastrophe bond (“cat bond”), which offers insurance coverage against certain losses caused by hurricanes, floods, windstorms, and so on, mortality bonds provide coverage against bird flu, swine flu, or any other pandemic that would create havoc in the financial sector.

The structure of these bonds in their simplest form is as follows: An investor purchasing a morality bond would receive an annual coupon payment for a specified amount of time, possibly a bond that costs $100 and pays 7% for five years. Attached to the bond is a predetermined threshold of mortality linked to the bond seller’s books. If the bond issuer (or seller) is a life insurance company, for example, the mortality threshold could be estimated losses the carrier would suffer if swine flu killed 5% of its customers. In such an extreme event, the carrier may not have the funds to make good on the life insurance policies owned by its customers, so an extreme mortality hedge is necessary. In the event of extreme mortality, the bond buyer’s funds would be used to pay the insurance carrier’s losses. If no such event occurs during the five-year period, the investor would have his principal returned and would have earned the 7% annual coupons for five years. The thresholds on these bonds can be defined in a number of ways:

• Indemnity: Triggered by the issuer’s actual losses.

• Modeled loss: As opposed to actual losses, use modeled simulations to determine a hypothetical threshold.

• Indexed to industry loss: Total loss of a specific industry or through the use of a longevity mortality index.

• Parametric: The degree to which the extreme mortality would occur.

• Parametric index: More applicable to natural catastrophe bonds, rather than extreme mortality bonds.

Although covered separately in this section, pools of life settlement policies are sometimes grouped as mortality bonds; however, their uses differ from what was just described. Figure 2.3 groups both but still accurately reflects the growth in the XXX bond category.

Figure 2.3. XXX bond issuance

Source: Fitch Ratings

On November 24, 2009, Swiss Re sold roughly $75 million of mortality bonds, which insured against potential losses triggered by the swine flu or terrorist attacks. According to a statement, investors will receive 6.17% above a benchmark rate provided that mortality rates do not exceed a predetermined “trigger” level.

Longevity Risk: The Nail in Japan’s Coffin

In my opinion, there is no better example of the economic implications of an aging society than Japan, the oldest and most indebted nation on the planet. Although some of the problems facing Japan’s economy were mentioned in the preceding chapter, this section provides a more detailed view of the negative effects of longevity and mortality risk when it is misunderstood and poorly managed. Japan’s problems are nothing new and have been written about extensively by economists and research analysts. In fact, many have even tried to bet against Japan—namely, through Japanese government bonds (JGBs)—wagering that close to 0% interest rates would rise through the 1990s and even the early part of the 2000s. These investors have almost always been wrong, and many within the hedge fund community deemed this kind of trade “the widow maker.” But the missing component in all the analysis is demographics. Not that anyone ignored the demographic component, but 10 or 15 years ago the population was, well, 10 or 15 years younger. As mentioned in Chapter 1, starting in 2010, Japan’s population has been in secular decline. In addition, people are living much longer in Japan; it has one the longest average life expectancies in the world. This growing number of seniors is putting a tremendous strain on public and private retirement systems. And because these seniors are the largest lenders to the Japanese government, any change in the financial stability of this cohort could spell disaster for the country as a whole. Although demographers have seen Japan’s demographic problem coming for years, it’s a very difficult dilemma to solve, so the problem has not been addressed in any material way. More than anything the nation has severe leadership issues, shuffling through several financial ministers and other key government posts in only a few years.

Fiscal Troubles: An Economic Background

Comparing Japan’s GDP to other financial statistics helps us evaluate the effectiveness of monetary policy in line with current and future growth prospects. Throughout the early 2000s, Japan and the U.S. have been running relatively large fiscal deficits—approximately 6% and 3–4% of the GDP, respectively. These numbers, while important to consider, do not seem outrageous by themselves. Looking at the countries’ debt-to-GDP ratios, however, reveals a much different story. In 1991, Japan’s debt-to-GDP ratio stood near the average for all the G7 countries, but it was lower than the ratio for Italy, Canada, and the U.S. Ten years later, Japan led the G7 nations with a ratio of approximately 120%. This number would continue to grow at a rate of 10% a year, further separating Japan’s indebtedness from that of the rest of the world. As of February 2011, Japan has above a 190% debt-to-GDP ratio. It is projected to surpass 200% by the end of the year. That would make it the highest debt-to-GDP ratio seen out of wartime by any developed country. Japan’s debt-to-GDP ratio is almost double that of Greece, whose ratio stands at 115.1%. Interestingly, Greece, Portugal, Spain, and Ireland receive the majority of attention regarding the likelihood of sovereign debt defaults. These “Club Med” nations have contributed far less value to the global economy than Japan, the third-largest economy in the world with a GDP of roughly $5.39 trillion. China surpassed Japan as the second-largest economy ($5.75 trillion) at the end of 2010, a trend that is sure to continue.

In Hubbard and Ito’s 2005 “Overview of the Japanese Debt Question,” the authors point out the importance of considering net liabilities as opposed to simply “gross” domestic product.² In other words, the government of Japan has a number of assets on its balance sheet, such as its own government and agency bonds as well as other securities, natural resources, foreign currencies, and so on. Japan owns roughly $1 trillion for foreign exchange reserves, of which about $882 billion is held in U.S. Treasuries. It is also important to note that, in contrast to other largely indebted nations such as the U.S., Japan has very little in the way of natural resources. Crude oil reserves in Japan are a marginal 45 million barrels as of 2010. To put that into perspective, Canada and the U.S. have some 179 and 21 million barrels of crude oil in reserves, respectively. Japan’s buffer of assets is limited to the securities owned by the government. When we take these assets into account and look at the ratio of net debt-to-GDP ratio, the fiscal problems in Japan look much less severe. In 2004, the net debt-to-GDP ratio was only 80%. Even when looking at the net ratio, however, the Organization for Economic Cooperation and Development (OECD) predicted last year that Japan’s 2010 net debt-to-GDP ratio would reach 104.6%. According to many economists, any nation with a gross debt-to-GDP ratio is at severe risk of default, let alone a net number.

When analyzing the fiscal health of any business, especially one that carries a substantial amount of debt, a prospective investor or lender attempts to gauge the company’s ability to service its debt. It also would look at how much revenue would need to be generated to turn a profit after satisfying its interest payments. A nation is no different. If a business issues 10-year debt around 1% on average but still struggles to meet its financial obligations, I believe a lender would start running in the other direction. In the case of Japan, this is not hypothetical but rather economic fact.

Japan’s outstanding debt has nearly tripled in the last three decades. Yet the government has enjoyed the privilege of paying extremely low interest on its debt to investors—less than 1% in most cases. Although the average rate paid in 1970 was approximately 6%, the number dipped below just 1.5% in 2009. Additionally, the spread between 10-year and 2-year JGBs has narrowed from more than 170 basis points in 2004 to less than 50 basis points last year. Now, add to the picture the fact that well over 90% of all outstanding JGBs are held by domestic investors. The Bank of Japan (BOJ) itself holds upwards of $500 billion in bonds on its balance sheet. According to Hugh Pym, chief economics correspondent for BBC News Tokyo, “risk-averse small savers, pension funds, and institutions”³ are the main groups that are content to hold JGBs. The fact that nearly all JGB subscribers come from within Japan acts as a sort of cover-up for the mountain of debt that has been steadily increasing over the years. In other words, in terms of debt issuance, the Japanese government has never had to worry about the global perception of its fiscal state. This is clearly no longer the case, as many problems have begun to surface on a public (both national and global) scale. The fact that six different officials have been elected Minister of Finance since 2008 signals that Japanese leaders recognize the need for change—an issue we will cover in depth while assessing the need for social change. In addition, the savings rate for both corporations and households has fallen to all-time low levels as the result of an aging population. Although the Japanese historically have been considered to be the world’s greatest savers (as measured by the amount saved as a percentage of household income), today this is not the case. Throughout the mid-1970s, the internal savings rate was approximately 20% of disposable income. In 2009, this number was just above 2%, in a year in which the fiscal deficit stood at around 7% of GDP. Such a low savings rate means that the internal demand for JGBs will inevitably decrease, because citizens will no longer have the money to purchase government assets. In fact, it has already begun to do so. With average yields on 2-, 5-, 10-, and 30-year JGBs at 0.19, 0.43, 1.21, and 2.12%, respectively, it will be difficult to attract a meaningful number of outside investors without significantly raising interest rates to levels competitive with the U.S. and Germany. So what does this mean? Harvard economist Martin Feldstein describes the situation as a “viscous spiral of rising deficits and debt that would be likely to push interest rates even higher, causing the spiral to accelerate.”⁴ Furthermore, the growing deficits will ultimately have a crushing effect on Japan’s current account surplus. A country’s current account equals its balance of trade (exports less imports) net interest payments and government transfer payments. For years, Japan has maintained a current account surplus because of its high private savings rate, an achievement on which it will no longer be able to rely. Feldstein makes it clear that “[Japan’s] cycle of rising deficits and debt will soon make national savings negative.”

In addition to the falling (near zero) savings rate, the nation has suffered from a tremendous decline in tax revenues (see Figure 2.4). Japan’s tax revenues, a nation’s lifeline, are at the same level as 1986, whereas its debt has tripled during the same time. A strengthening yen, which is fatal for an export-based economy such as Japan, a shrinking workforce, and the negative impact of the recent economic crisis all play a role in the declining tax revenue. Furthermore, as the yield on the government’s debt rises, more of the tax revenue must be allocated to servicing interest payments. According to the 2010 budget, 25% of the government’s expenditures are debt service, and rates hover around 1%. Moreover, an additional 30% or so is allotted to social security (see Figure 2.5)!

Figure 2.4. Japan’s fiscal condition FY2010

Source: Japanese Ministry of Finance

Figure 2.5. Japan’s initial budget FY2010

Source: Japanese Ministry of Finance

The problem does not stop here. Japan’s dire outlook will also have a negative effect on a number of major nations across the globe. As of November 2010, Japan is the world’s second-largest holder of U.S. Treasuries, with over $768 billion worth of American bonds on its books. Only China and the U.S. Federal Reserve own more. At some point, Japan will need to sell its foreign exchange reserves to purchase yen to fund its yen-denominated obligations. The largest of these obligations would be maturing debt and social security for retirees. Ironically, if the BOJ needed to swap U.S. dollars, euros, and pounds for yen, it might strengthen the yen, which would further cripple Japanese exports, further weakening the economy. Net selling of U.S. Treasuries by Japan would have a negative effect on the U.S., which currently maintains an approximately 85% debt-to-GDP ratio. If Japan liquidates a sizable portion of its foreign holdings, it could possibly send prices tumbling. This would increase the borrowing cost of the U.S. government, which faces its own looming social security crisis.

As mentioned earlier, another serious concern involves the appreciation of Japan’s currency. The Japanese yen (JPY) reached a 15-year high against the U.S. dollar (USD) in October 2010. Ultimately, a strong currency makes Japanese exports more expensive for other countries and, therefore, significantly less competitive on a global stage. Japan’s recovery from the 2008 recession is considered by many to be entirely dependent on the return in demand for its exports. Its most prominent exports are automobile and motor-related equipment, machinery, and vehicles; semiconductors and other electrical computing supplies; and pharmaceutical and medical equipment. In a September 2010 speech, Japanese Minister of Finance Yoshihiko Noda warned that “recent movements [in the yen] will have adverse effects on the stability of economic and financial conditions.” Noda’s finance ministry and the BOJ have proven that they will not shy away from artificial stimulus. However, the late-August 2010 meeting of the BOJ involved discussions and an eventual implementation of currency intervention. Adding to the JPY dilemma is, yet again, the fact that it is far from isolated. This issue must be considered a global issue instead of one confined to Japan or the Far East. Successful and impactful monetary intervention requires the cooperation of all nations involved, whether via trades and exports, foreign exchange reserves, or political motivations. Because domestic demand for its most popular products has been relatively dull for the past decade, Japan largely depends on its high-growth neighbor, China, and the distant U.S. for economic prosperity. Major Japanese-based global conglomerates such as Sony and Toyota depend on a healthy export economy (external demand) to maintain respectable levels of profitability. The recent sovereign debt crisis in Europe coupled with the slow recovery in the U.S. will make it extremely difficult for Japan to stir up external demand. It should be noted, however, that a weaker yen also lowers the cost of importing, which helps make up for Japan’s utter lack of natural resources. Despite the advantages of cheaper oil and other imported commodities, at the moment the costs of a strong yen far outweigh the benefits. Although the many fiscal issues could indeed be cause for concern individually, this is only the contextual backdrop for analyzing a more significant matter—demographics (in particular, longevity risk).

Demographics

Chapter 1 highlighted the importance of demographics through concepts such as “the spending life cycle” and other ways in which demographics can influence economies. This chapter has examined how corporations and governments can use the longevity/mortality risk markets to hedge the impact of population change—namely, longer-living populations. The economic issues plaguing Japan, which have already been highlighted, are compounded exponentially by Japan’s severe demographic problem—longevity risk. Unfortunately, demographics cannot be changed by economic policy.

According to traditional demographic standards, a society in which 7% of the citizens are age 65 and older is considered to be “aging,” and a society in which 14% of the people are older than 65 is termed “aged.” Although it has taken many of the world’s developed countries between 50 and 100 years to transform from aging to aged—more than 65 years in the U.S. and 115 years in France—Japan’s transition has occurred in just 24 years. One of the main reasons for this short time frame has to do with the extreme lengthening of life expectancies in Japan post-World War II. Between 1947 and 1970, the life expectancy for males in Japan increased from 50.1 to 69.3 and from 54 to 74.7 for females. In many ways, the longer life spans were the result of what historians have called Japan’s postwar “economic miracle”—the fiery growth of the country’s economy. This resulted from foreign investment, vertical integration of large corporate enterprises, and industry-wide cooperation. Additionally, substantial American investment and economic intervention allowed for enormous growth and, in turn, unforeseen technological and medical development. During this period, individuals and families saw drastic increases in both their personal and cumulative household incomes. Ultimately, Japanese citizens were able to take better care of themselves and live healthier and more productive lives. Japan’s National Institute of Population and Social Security Research (NIPSSR) has published a series of fascinating charts depicting the country’s “population pyramid”⁵ (see Figures 2.6 through 2.8). In 1950, the vast majority of the country’s population was younger than 55. As with any baby-boom decade, most are under the age of 20. By 2010, however, the visualization looked quite different—more like a diamond than a pyramid, a change indicative of the population’s upward age shift. Here, more than 50% of Japanese citizens are between 25 and 65 years of age. NIPSSR predicts that the chart will take on the shape of a kite by 2050, as more people age and the percentage of young people continues to decline. Between the years 2045 and 2055, it is forecast with high probability that Japan’s working-age population will shrink to a size smaller than its 1950 levels, with four out of 10 citizens over the age of 65.

Figure 2.6. Population pyramid 1950

Source: NIPSSR

Figure 2.7. Population pyramid 2010

Source: NIPSSR

Figure 2.8. Population pyramid 2050

Source: NIPSSR

Because of Japan’s aging population—indeed, Japan is now the oldest country in the world, with three people of working age for every person of pensionable age (a ratio expected to increase to 1:1 by 2040)—an overall decrease in population size has already started to occur. This decrease is largely due to a mortality rate that is higher than the current fertility rate. Despite efforts by the Japanese government to increase the birth rate throughout the 1970s, Japan’s current level of 1.3 children per woman solidifies its status as one of the lowest-birth-rate countries in the world. Due to the almost unbreakable relationship between childbirth and marriage, it is especially difficult to increase procreation rates in Japan’s modern society. A growing number of younger women are deciding to marry later in life or to remain unmarried indefinitely. Another problem is that private companies rarely reserve positions for women who want to return to work following a maternity leave. Therefore, women who want to reenter the workforce usually accept temporary or irregular positions, often backtracking in terms of job prestige and qualifications. For these reasons, it is clear that childbearing at a young age is neither attractive nor realistic for the vast majority of Japanese women. The fact that Japan’s population is both aging and shrinking, then, is a dual threat to the world’s third-largest economy. Ultimately, the working-age-versus-pensionable-age ratio, or dependency ratio, is one of the most important tools when determining the effect of demographics on economic growth. Economists around the globe agree that a healthy working-age population is necessary for any sort of meaningful productivity; put simply, GDP requires labor to grow.

Japan’s historically high savings rate and its resulting investment in productive capacity are useless without a workforce in place to utilize them. When compared to the other G7 nations, Japan’s working-age population has been diminishing by the largest percentage per year since 1995. It’s expected to decrease by just under 1.5% between 2035 and 2045. This statistic alone is enough to predict that Japan’s economic growth due to labor productivity will lag far behind the rest of the developed world and ultimately will be responsible for meager if not negative GDP growth.

Some people hope that immigration may be able to save Japan, but most consider this idea far-fetched for such a closed society. Japan’s immigration policy has historically been one of the strictest in the world. The 1952 Immigration Control Law was the first prominent legal framework for solidifying immigration policy in postwar Japan. Although not explicitly stated in writing, it became clear that in many ways it was designed to prevent the permanent settlement of foreigners in Japan. This veiled implication seems to have made its way into the revised immigration policy in place today. In 2004, the Justice Ministry amended the Immigration and Control and Refugee Recognition Act to further decrease the number of foreigners allowed into the country. As a result, only a quarter of a million new immigrants enter each year. The main disadvantage of importing foreign labor as a solution to the declining working-age population is that this would simply postpone the problem. Also, immigrant labor has its costs. As Kotlikoff and Fehr argue in their 2004 paper titled “The Role of Immigration in Dealing with the Developed World’s Demographic Transition,” “Immigrants are not free. They require public goods and services, and they also demand the same transfer payments as the indigenous population.”⁶ The authors ultimately conclude that using immigrants to solve productivity-related economic issues would “likely cost the Japanese fiscal authorities almost as much as they would generate in additional revenues.” Similar conclusions are found by McKinsey & Co. in a study examining the household savings rate in Japan: “Increasing immigration, even at the highest levels projected by government statistics, is not large enough to change overall demographic structure, and thus does not materially impact net financial wealth accumulation.” When looking at the historical numbers of immigrants, one might become justifiably skeptical when assessing the possibility of a changing attitude toward immigration. Between the years of 1975 and 2001, total immigration accounted for less than 1.5% of the total 2001 population. This minimal percentage of new entrants into Japan highlights the magnitude of change necessary to combat the looming demographic threats.

The major issue with a demographic problem, such as the one in Japan, is that it hinders future growth as well. Not only are current assets eaten away by ballooning pension and debt liabilities, but the shrinking workforce stifles future progress. Japan’s bread and butter has been technology—the ability to export cutting-edge appliances and electronics to the rest of the world. Why can’t Japan simply innovate its way out of its problems? Unfortunately, Japan’s population is shrinking much faster than any potential gains would arise. Who would manufacture these novel technological products? Possibly Korea? China? But other Asian nations are creating their own technologies that are more currency-friendly to the West and that are of equal if not better quality. LG, a South Korean company, is an excellent example. Moreover, outsourcing production will do little for Japan.

Although technological advancement could potentially relieve some of the pension and health care obligations that come as a result of the aging epidemic, it is by no means guaranteed that Japan’s political and financial leaders would act accordingly. It is extremely difficult to accurately measure the rate of technological growth in an industry, local economy, or country. A widely accepted method is to use the measure of the Solow residual—a number describing the growth in an industry or economy that cannot be explained by the accumulation of capital or other factors such as an increase in land or labor.

According to Kato, “a 1% difference in the annual rate of technological progress results in a substantial difference in future GDP over the relevant horizon.”⁷ Technological progress in Japan as measured by variations of the Solow residual has hovered around zero for the past 20 years. Kato’s projections show that a 1% reduction in the rate of technological progress can produce an approximately 18% fall in per capita income—a significant statistic to consider when evaluating the effectiveness of instituting nationwide technology-boosting programs. Bessho, Ihori, et al.’s general equilibrium model predicts that an expansion of future technological progress both helps increase GDP and “results in an increase in the future equilibrium interest rate.” This rise in the interest rate is a particularly important finding because of its unavoidable association with rising interest payments on Japanese government debt. The authors suggest that a significant raise in the consumption tax rate will be necessary to finance the massive amount of outstanding debt. The issue of openness, although already discussed in terms of immigration, has much to do with technological development as well. Many U.S. and European conglomerates accumulate talent from around the globe to develop the most innovative and advanced products. They realize that brilliant entrepreneurship is both a finite and limited resource and that an outward-looking attitude is a prerequisite for success. On the contrary, the Japanese rely almost solely on homegrown scientists and engineers to conduct any sort of extensive research and development programs.

When looking at Japan’s aging problem, we must step back and realize that, as an isolated topic, longer life spans for Japanese citizens is primarily a good thing. This means that the population is healthy and has access to world-leading medical technologies, and that the overall quality of life is superior to many other countries. As expressed by Henry J. Aaron in his Brookings Institution working paper titled “Medium-Term Strategies for Long-Term Goals,” “rather than being bad news, increased longevity is the culmination of human efforts spanning centuries to extend the duration and quality of life.”⁸ Surely Japan cannot morally consider diminishing the budget for medical development and life-saving pharmaceutical innovations. Aside from the two major propositions discussed in this chapter, a number of minor yet certainly plausible suggestions have been put forward.

First, we consider the effect of increased female presence within Japan’s working-age and elder workforce population. 1968 marked the first year since World War II in which the younger working-age population began to decline (particularly those aged 20 to 39). Here, Japanese companies turned to a new source of labor to fill the rapidly enlarging gaps—middle-aged women. Less than a decade later, in 1976, the percentage of employed women aged 40 to 54 would begin to increase. The salaries of these women were tremendously low compared to industry averages, however, and firms invested most of these low-pay-related savings into automation techniques. It was widely believed at the time that the automation of rudimentary tasks would lead to indefinitely sustainable increases in firmwide productivity. However, there is a certain level of capital intensiveness, K, where production output starts to flatten and value added begins to decrease. Each level of capital intensiveness beyond point K continues to see linearly rising production costs. Since the mid-1970s, Japan has operated to the right of the capital intensiveness threshold—to the right of K—artificially pushing production beyond the healthy levels supported by a combination of human and automated labor. Such irrational corporate behavior is largely responsible for sluggishness in any sizable economy. According to a 2008 report by the OECD, Japan is in last place in terms of utilizing the available pool of well-educated female workers. The report calls Japan’s gender-related hiring practices a “considerable waste of valuable human resources...which need to be addressed urgently, notably in the actual context of population aging.” This inefficient and discriminatory labor usage is particularly surprising in light of the fact that Japanese women are as a whole better educated than in nearly all other OECD countries. (Only Canada and Finland have a greater percentage of women with university degrees.) While the OECD average of women with college degrees stands around 28.5%, over 42% of Japanese women possess such academic qualifications.

A November 2010 special report in The Economist highlights the gap between male and female workforce participation as being “larger than any other developed country.” This has much to do with the fact that women are not given the same opportunity to succeed via firm-specific managerial programs—programs designed to nurture talent internally and develop future executives. More often than not, males are considered to be the ideal candidates for such “managerial fast track” programs. Gender-biased hiring practices can be seen at all levels of the corporate world. As of 2011, only 16 female executives exist within Japan’s equivalent of the Fortune 100.

Japan will need to devote serious effort to finding a feasible solution sooner rather than later. Of course, this will be a combination of efforts instead of a single, solve-all proposition. We have not yet discussed Japan’s pension system, which, as it turns out, is one of the nation’s top issues—a culmination of the problems related to labor shortages and an aging society. Along with the title of the oldest population in the world comes a tremendous strain on Japan’s pension and health care systems, as well as the potential change in both corporate and personal tax structure. Because of unprecedented economic growth throughout the 1960s and 1970s, the Japanese pension system was globally renowned as one of the world’s most generous. Accordingly, a pay-as-you-go scheme was most appropriate for a booming economic climate and favorable demographic composition. However, after decades of economic stagnation throughout the late 1990s and 2000s, change would become necessary. If benefits were to remain at their 1960s and 1970s levels, Japanese citizens would have to contribute more than one-fourth of their annual income. Because of the severely depressed savings rate of the average Japanese household, this would be demographically impossible. Therefore, the 2004 pension revision sought “to delicately balance benefits and contributions over the next century.” This particular revision established that Japanese citizens would contribute a growing percentage of their income each year until 2017, at which point the rate would be frozen at 18.3% of income. Also, the age at which citizens may receive pension benefits was set to gradually increase over time. This pension structure is predicted to decrease benefits by approximately ¥350 trillion by 2100. According to Kohei Komamura’s 2007 study in the Japanese Journal of Social Security Policy, such a reduction would move the ratio of pension expenditures to GDP below its current level to 9% by the year 2025.

Despite the steps taken to prevent a collapse of the outdated pension system, much of its success is only predicted or hypothetical. We have yet to see how it will fare when placed alongside the other economic issues. A November 30, 2010 article in the Financial Times titled “Japan Looks at Pension Fund to Cover Shortfall”⁹ is a perfect example of a potential impediment to the success of pension system reform. With the government expected to pay half of all pension benefits, extracting capital from the pension reserve fund could prove to be an irreversible mistake. Ultimately, the government faces the formidable challenge of devising a pension scheme that increases old-age benefits with the aid of a shrinking working-age population. According to Yoshihiko Noda, “it will be extremely difficult to secure the ¥2,500 billion (approximately $300 billion) in financing needed to meet the treasury’s obligation.”

Social/Cultural Issues

Japan’s fiscal and demographic problems will ultimately trigger the need for social change as well. Corporate rigidity, seniority-based compensation, and lifetime employment guarantees are just a few traditional Japanese customs requiring revision if Japan is to move from economic stagnation to consistent growth. As Akihiko asserts in Shrinking Population Economics: Lessons from Japan: “The demographic change under way in Japan thus mandates fundamental change in economic policy and in business management.”¹⁰ We will explore this change in management, business processes, and leadership.

The practice of “lifetime employment” has been used by many major Japanese firms since the nation’s period of unprecedented economic growth post-World War II. As argued by Chiaki Moriguchi and Hiroshi Ono in their 2004 paper “Japanese Lifetime Employment: A Century’s Perspective,” the practice is “[both] an economic [and] a social institution”¹¹ that is “characterized by an implicit contract and reciprocal exchange of trust, goodwill, and commitment between employers and workers.” Emphasis must be placed on the social forces at play, because Japanese cultural standards and traditions are held to be of the utmost importance. In economic terms, many scholars have argued against lifetime employment as an effective practice, mainly stating its inability to coexist with financial uncertainty. That is, guaranteed lifelong employment leaves minimal room for labor flexibility in a fluctuating business climate. Ono’s 2010 discussion about the actual measurement of lifetime employment statistics in Japan stresses that “the falling birth rate and the rigid employment system are in fact intricately linked.” The main reason for this is the difficulty of returning to work following a period of extended absence. Clearly this reality is especially difficult for women returning from maternity leave, and therefore may be considered a significant cause of Japan’s rapidly declining fertility rates. As a result, Japanese employers may have to revamp their hiring practices to become both more flexible and attractive to those searching for a reasonable work-life balance.

With the oldest population in the world, Japanese companies will have to evaluate how such a shift in demographics (namely, the change in age structure) will affect their day-to-day operations. Product lines and processes will ultimately need to undergo some major revisions, which will likely involve the streamlining of wasteful operating procedures and the downsizing of the workforce in divisions no longer contributing to the firm’s bottom line. Akihiko asserts that lifetime employment “would hinder companies in accomplishing the transformation necessitated by Japan’s shrinking and aging population.” In line with the changing business landscape, companies will need the flexibility to either increase or decrease their workforce and make selective hiring decisions based on new products and new demand. Japanese firms’ hesitancy to stray from such a uniquely Japanese tradition has been the primary blockade to a much-needed social transition.

The dispersion and deflection of responsibility at all levels of Japanese society is another element that does not go well with accepting and embracing the need for change. This is clearly evident when looking at the number of different leaders within the Japanese government since 2006. For example, Junichiro Koizumi, Prime Minister of Japan from 2001 to 2006, is the only prime minister since 1972 to last more than five years in office. Since the end of Koizumi’s tenure in September 2006, there have been five prime ministers, 11 agricultural ministers, six foreign ministers, six ministers of internal affairs and communications, seven defense ministers, and eight finance ministers. It should be noted that the term length of each position is four years or less, and legislation states that “no limits are imposed on total times or length of Prime Minister tenures of the same person.” A November 2010 article in The Economist argues that “any sensible democracy should know that changing ministers so quickly is detrimental to policymaking.”¹² This is clearly the case in Japan, because the rapid leadership change will ultimately delay any decision making regarding its dangerous levels of debt and deflation. Additionally, strong and intelligent leadership across all government ministries is necessary to drive internal growth within an elderly society. Change, specifically within the Ministry of Finance, causes significant delays in the country’s fiscal initiatives, because coordination between the MOF and the BOJ is crucial for currency interventions and other types of stimulative measures.

Conclusion

Although economists around the globe have had their eye on Japan’s economic and fiscal state for a number of years, many have neglected the looming demographic catastrophe. The primary reason for this ignorance is the fact that decades have passed without any truly detrimental consequences. This chapter has shown why Japan’s troubles can no longer be postponed. If the various government ministries work together and realize the need for swift and sweeping change, a crisis might be averted. Although other industrialized nations will ultimately face the daunting challenge of an aging population, Japan has the unfortunate privilege of being the first to weather (or fall victim to) the storm.

Endnotes

¹ See Antony Mott, Chapter 15, “Synthetics in Life Markets: Trading Mortality and Longevity Risk with Life Settlements and Linked Securities,” 25-31 (Vishaal Bhuyan, ed., 2009), available at http://books.google.com/books?id=UkuzHLKPOW8C&pg=PA25&lpg=PA25&dq=debit+methodology&source=bl&ots=rdiU8mJ072&sig=GAxBEE2tyjnq1QHXIOB75i9xCh0&hl=en&ei=YgehS4nGI4aBlAfq6NCbDg&sa=X&oi=book_result&ct=result&resnum=9&ved=0CDMQ6AEwCA#v=onepage&q=debit%20methodology&f=false (prerelease form).

² Hubbard, R.G. and Ito, T. “Overview of the Japanese Debt Question” (in Kaizuka and Krueger, 2006).

³ Pym, Hugh. “Japan: Debt, Demographics and Deflation.” BBC News (Business). BBC, November 30, 2010. Online. December 10, 2010. http://www.bbc.co.uk/news/business-11867257.

⁴ Feldstein, Martin. “Japan’s Savings Crisis.” Daily News Egypt, October 1, 2010. Online. December 10, 2010. http://belfercenter.ksg.harvard.edu/publication/20397/japans_savings_crisis.html.

⁵ National Institute of Population and Social Security Research. “Population Pyramid 1955, 2010, 2055.” Extracted from NIPSSR website, December 10, 2010. http://www.ipss.go.jp/sitead/TopPageData/Pyramid_a.html.

⁶ Kotlikoff, L.J. and Burns, S. The Coming Generational Storm. Cambridge: MIT Press, 2004.

⁷ Ihori, T., Kato, R., and Kawade, M. “Public Debt and Economic Growth in an Aging Japan.” Working Paper, Faculty of Economics, University of Tokyo (2005).

⁸ Aaron, Henry. “Medium-term Strategies for Long-term Goals,” in Tackling Japan’s Fiscal Challenges: Strategies to Cope with High Public Debt and Population Aging, edited by Keimei Kaizuka and Anne O. Krueger, International Monetary Fund, 2006, pp. 79-104.

⁹ Whipp, Lindsay (for the Financial Times). “Japan Looks at Pension Fund to Cover Shortfall.” Financial Times, November 30, 2010. Online. December 8, 2010. http://www.ft.com/cms/s/0/76330324-fcba-11df-bfdd-00144feab49a.html#axzz18gi4sEER.

¹⁰ Akihiko, Matsutani. Shrinking Population Economics: Lessons from Japan. Tokyo: International House of Japan, 2006.

¹¹ Moriguchi, Chiaki and Ono, H. “Japanese Lifetime Employment: A Century’s Perspective.” EIJS Working Paper Series No. 205 (2006).

¹² Tricks, Henry (for The Economist). “Into the Unknown: A Special Report on Japan.” The Economist, November 20, 2010.