Market turbulence caused by the coronavirus pandemic looks set to hit Japanese defined contribution (DC) pension plans particularly hard, as they are prohibited from investing in most alternative assets, notably private markets.

A wider choice of investments would help reduce risk and boost returns, while schemes should also consider rebalancing their portfolios as the recent volatility will likely have sparked wide divergence from their target allocations, suggest industry experts.

Many Japanese corporations have shifted their employees’ pension schemes to DC from the less investment-constrained defined benefit (DB) model in recent years – for good reason; it reduces their balance-sheet risk. 

DC schemes covered 40.3% of people enrolled in corporate pension schemes as of the end of March 2017, according to the latest available data from Japan's Ministry of Health, Labour and Welfare (MHLW). They held assets under management of ¥12.5 trillion ($114.1 billion) as of March 31 last year, a fifth of the ¥63 trillion in DB funds, but DC fund assets are growing.

Konosuke Kita,
Russell Investments

However, equity and fixed income are the main asset types they can allocate to. Only a few liquid alternative investment classes are allowed, such as gold and real estate investment trusts, said Konosuke Kita, director of consulting in Japan at Russell Investments.

As a result, Japanese DC funds' performance is typically lower than that of their DB counterparts. In the financial year ended March 31, 2018, DB plans returned an average of 4.45% while DC schemes returned 3.1%, according to data from Japan’s Pension Fund Association.

SHORTFALL WIDENING?

That discrepancy could well be even wider when the next set of data emerges, thanks to the huge global stock market falls since February. This starkly points to the need for access to potentially higher-yielding products.

“I think most of the individual participants in DC will find the returns after this [coronavirus impact on equity markets] to be negative, or some may not know until they get their annual report,” Kita told AsianInvestor.

By contrast, some of the larger Japanese DB corporate pension funds have benefited in recent years from diversification into illiquid private assets. In 2017, 65.1% of DB funds invested in alternatives, with 48.3% allocating more than 15% of their portfolio to the asset class, according to MHLW.

Given the low yields available on fixed income, especially from Japanese government bonds, equity has been seen as the place to get some upside. That allocation is now losing value fast due to the Covid-19 outbreak. 

Moreover those recent equity market losses have also meant that these DC schemes need to consider rebalancing their portfolio closer to their targeted allocation mix. 

Masaaki Sakakibara,
Mercer

Last month consulting firm Mercer released a report for investors called Rebalancing in troubled markets. It assessed that as a result of market movements this year to March 17 alone, a target portfolio comprising 60% global equity and 40% global government bonds would have shifted to about 52% equity and 48% bonds.

That represents a significant deviation from the target allocation in a very short time and would skirt or breach the asset allocation tolerance ranges in many investment policies, Mercer said.

The consulting firm recommended that clients consider rebalancing their exposure at least halfway to their targets to the extent possible. Rebalancing can potentially enhance returns, but most importantly it is a risk-control measure, Mercer said. 

Markets will ultimately touch bottom and rebound and, in the absence of rebalancing, it would be difficult for the portfolio to keep up with a policy benchmark and recover lost value, the report added. 

EDUCATIONAL CHALLENGE 

Ultimately, the shift from DB to DC has passed the burden of retirement funds’ performance onto the employees. Hence corporations in general do not worry about the lack of alternative investments in the portfolio mix, said Masaaki Sakakibara, leader of the wealth business in Japan at Mercer.

“Challenges for corporations are more in the form of educational obligations, as most employees are not well educated in terms of financial literacy,” he told AsianInvestor. "They need investment knowledge, such as active or passive, balanced or single asset and risk or principal guaranteed."

But there have been improvements on this front, so individuals may be better protected than in the past.

Increasingly, more people have DC pension plans, and some are even considering personal schemes. Over the last 20 years, the general approach on how to handle pension assets has changed, Russell’s Kita said.

“I can say that people have become more insightful than before," he added. "My view is that 20 years ago most of the individual investors were thought to be performance chasers, but after the global financial crisis [of 2008] some of the DC investors have become more cautious, and at times even contrarian to general market sentiment."