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Shinzo Abe is on track to become the longest-serving prime minister in Japanese history in November 2019, having recently secured another three-year term as leader of the Liberal Democratic Party (LDP). With his legacy in mind, Abe is signaling a desire to use whatever remaining time he has left in office to tackle several politically difficult challenges. Near the top of his list is another round of changes to the nation’s social security system, to counteract the effects of population aging. Abe is suggesting raising the retirement age (again) while also offering incentives to workers to remain active until age 70 and beyond.

Abe isn’t the first Japanese leader to tackle the financial burdens associated with the country’s growing number of elderly citizens. Japan’s demographic transformation first came into view in the 1960s and 1970s and prompted an initial round of social security reforms in 1985. Those changes were quickly found to be insufficient because they were based on overly optimistic assumptions (from an actuarial point of view). The government conducted a series of mandatory five-year reassessments of the social security program from the 1980s to the early 2000s, and each of them showed the financial outlook getting worse relative to the previous forecast. In response to these projections, political leaders were forced to take up repeated rounds of benefit adjustments and tax hikes. Abe’s initiative should be seen as another chapter in this decades-long saga of national reckoning with demographic reality.

While all advanced economies, including the U.S., are struggling with aging populations, Japan stands out — it is commonly referred to as the world’s oldest society — because of its exceptionally long lifespans and the early and steep decline in birth rates the country experienced in the 1950s.

According to the UN’s most recent projections, the share of the Japanese population that was age 65 and older in 2015 was 26 percent. That compares to 14.6 percent in the U.S., 18.9 percent in France, 21.1 percent in Germany, and 22.4 percent in Italy. Further, Japan had a total fertility rate (TFR) — a measure of births per women of child-bearing age — of 1.41 from 2010 to 2015. Over that same period, the TFR was 1.88 for the U.S., 1.98 for France, 1.43 for Germany, and 1.43 for Italy. Japan’s TFR fell quickly in the post-war period, to 2.17 for the years 1955 to 1960, which was down from the TFR of 2.96 that the country experienced from 1950 to 1955. Most other advanced economies experienced much larger and longer “baby booms” after the war.

Japan has now experienced four straight decades of birth rates below the population replacement TFR of 2.1. Low rates of birth, and limited immigration, lead inexorably to a contracting workforce, which is debilitating for a pay-as-you-go pension system. Japan’s working age population — those age 20 to 64 — peaked nearly two decades ago. In 2000, there were 79.4 million people in Japan who were in this age group. By 2015, the number had dropped to just 72.1 million people. The UN’s median projection scenario forecasts Japan will have just 50.8 million people age 20 to 64 in 2050 — a remarkable 36 percent contraction over a half century.

Japan’s steady improvement in lifespans and its declining workforce has created tremendous financial pressure within the nation’s social security program. Japan’s system shares similarities with U.S. Social Security. It combines social welfare goals, which are met with income transfers, with an earnings-related benefit, and the system is financed mostly with payroll taxes imposed on current workers. Japan differs from the U.S. in that it chose to divide up its program into two tiers. The first is a flat-rate benefit, called the National Pension (NP), which gets half of its funding from a government subsidy financed outside of the payroll tax; the second is the earnings-related benefit, or Employees’ Pension Insurance (EPI).

Japan’s government actuaries use a calculation of the payroll tax rate necessary to keep the program solvent on a long-term basis as a summary measure of the system’s financial outlook. In 1992, projections showed the tax rate would need to rise to 26.8 percent of payroll to finance full NP and EPI benefits on a permanent basis; the tax rate at the time of the forecast was 11.2 percent. The government responded in 1994 by gradually raising the retirement age for the NP (from 60 to 65) and by changing the annual indexing formula for benefits to slow their growth rate.

Even with these adjustments, however, projections in 1997 again showed the tax rate would need to climb to above 26 percent to keep the system solvent. In 2000, the government enacted another round of benefit changes, including raising the retirement age for the EPI to match the NP. The government also lowered the rate of benefit indexation still further to hold down the rate of growth of total pension spending.

The 2000 reform provided a very temporary reprieve from financial pressures. By 2002, government projections once again showed the NP and EPI were facing a large, permanent financing deficit, as the assumptions used in 2000 were found to be too optimistic.

Exasperated by having to engage in repeated and politically controversial efforts to keep the retirement system solvent, the Japanese government chose a different approach when it next took up reform in 2004.

The first step in that effort was a reluctant agreement to schedule a rapid and steep hike in the payroll tax rate, from 13.58 percent (split evenly between employers and employees) in 2004 to 18.30 percent in 2017 — a cumulative 35 percent increase in the applicable rate.

Next, the government worked to assure the public, and the business community, that this would be the last tax hike ever needed to finance the social security program because an “automatic stabilizer” would adjust benefit payouts as necessary to keep total spending in line with available payroll tax revenue. This new benefit adjustment mechanism was modeled on similar provisions adopted by Sweden and Germany to keep their state-run pension systems solvent without the need for repeated interventions by political leaders.

Japan’s automatic stabilizer — called the “macroeconomic slide” — works by adjusting the wage indexing used to calculate initial eligibility for benefits and the price indexing used to increase benefits for retirees already in payment status. The adjustment to regular indexing is based on the rate of change in the number of working age people paying into the system and on changes in the life expectancy of retirees.  As the workforce contracts, and retirees live longer, the stabilizer reduces the indexing of benefits for retirees.

The stabilizer is expected to greatly improve the financial outlook of the social security program in coming years by reducing benefits for future retirees. According to the latest five-year actuarial projection, released in 2014, the replacement rate, defined as the ratio of the pension benefit to average lifetime wages for a typical earner with a non-working spouse will drop from 62.7 percent in 2014 to 51.0 percent in 2043. The law stipulates that the replacement rate for the typical worker, plus a spouse, cannot fall below 50 percent; if it were to do so, the government would need to enact new reforms to address the financing shortfall. If this protection were not in place, the replacement rate would fall to 42 percent in 2058 based on current demographic assumptions.

Although Japan is counting on the automatic stabilizer to keep its social security system solvent, it has only been invoked once over the last decade (in 2015). In addition to setting a floor on the replacement rate, the law also provides that during periods of deflation (when price inflation is nonexistent or negative), the stabilizer will be suspended to prevent imposing an absolute reduction in monthly pension benefits for retirees. Japan’s economy has been in a long period of slow growth and deflation, and so during most of the period after the 2004 reform was enacted, the stabilizer was suspended even though demographic shifts should have resulted in lower indexing of pension benefits.

Suspending the stabilizer during this period means that the benefit reductions necessary in the future will need to be larger than they otherwise would have been to keep the system afloat. In effect, suspension of the stabilizer has helped current retirees at the expense of those who will retire in the future. In 2017, the Japanese Diet approved another change in the social security law that will allow the stabilizer to capture, in the years immediately following the suspension, the value of the benefit adjustments missed during periods of deflation. This modification to the 2004 reform should ensure more fairness across generations of retirees.

While the 2004 benefit adjustment mechanism was a step forward (if it is allowed to take effect), it will not solve Japan’s entire retirement challenge. The system remains under strain because of the steady increase in the ratio of retirees to workers. Under current law, the stabilizer provides a partial solution by triggering steep cuts in the replacement rate for future retirees, but these cuts raise the concern that some retirees will be forced to live with inadequate income support during their final years.

Many pension experts believe Japan, along with other advanced economies, will need to do more to delay retirement beyond age 65, and to encourage workers to stay employed as long as their health allows. Efforts along these lines are a win-win from a social security perspective: They expand the workforce paying into the system even as they also lower the number of retirees drawing benefits.

But they aren’t easy to enact. Raising the retirement age is no more popular in Japan than it is in the U.S., which is why Abe is considering such an increase only as he eyes his exit from elected office.

The reality is that Japan has no good options. When people live longer and have fewer children, the inevitable consequence is a shrinking pie from which to draw retirement benefits. The pie can be expanded by having workers stay employed longer, and the portion going to retirees can be reduced by having workers retire later in life. But these shifts won’t be enough to offset the effects of a rapid contraction of the workforce.

Abe should be commended for taking up social security reform during his final years in office. It is a difficult challenge. But no one should think that whatever he is able to accomplish will be the final word on the matter. This is a problem that long predates Abe’s tenure and will remain a major challenge long after he has left office.

James C. Capretta is a RealClearPolicy Contributor and a resident fellow at the American Enterprise Institute.

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