GPIF - Ant, Grasshopper and Widowmaker

7/28/2019 GPIF - Ant, Grasshopper and Widowmaker

1/8J UL Y / AU G U S T 2 01 2 I NS T I TU T IO NA L I NV E S TO R . C O M

TTHE AIR INSIDE THE GOVERNMENT PENSION INVESTMENT FUNDSTokyo headquarters was as warm and dry as a spaceships. As president TakahiroMitani and his colleagues filed silently into an austere meeting room, I was sweatingslightly, struggling to compose my question with the correct level of Japanese politesse:How did the worlds largest pension fund decide on such a conservative level of riskand return for its portfolio?It was far from an idle question. The GPIF has 108trillion ($1.36trillion) in assetsunder management. Thats nearly six times as much as the California Public Employ-ees Retirement System, the biggest U.S. pension fund, and nearly four times as muchas Europes largest pension plan, Stichting Pensioenfonds ABP of the Netherlands.Even more striking than the funds gargantuan size is its composition: Fully three

quarters of the GPIF is invested in bonds, including 58.4trillion of domestic bondsand 14.4trillion of government agency debt.

Many large Western pension funds, led by pioneers like CalPERS and ABP, havechosen to reach for yield, a choice they know exposes them to big market swings. For

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Japans giant government pension fund sitson a mountain of government bonds

a low-return and potentially high-risk strategy.

BY JAMES SHINN

Widow-maker


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GPIF president Mitani pursues a conservative investment strategy at the pension fund. Will it deliver the returns that Japans retirees need?



some of these funds, the portfolio losses of 200809 were near-death

experiences (CalPERSs assets plunged 38 percent), pushing their

funding ratios down into the red zone. Yet most of these funds are

trying to grow their way out by continuing to bet heavily on equities

and making ever-larger allocations to private equity, hedge funds,real estate, infrastructure and other illiquid assets.

But not the GPIF. At the end of 2011, the Japanese fund had 67.4

percent of its portfolio invested in Japanese bonds, 11.1 percent in

Japanese stocks, 8.4 percent in foreign bonds, 10.1 percent in foreign

stocks and 3 percent in short-term assets. No exotic long-dated assets

anywhere. And fully 80 percent of the portfolio is invested passively.

The GPIFs financial conservatism is all the more striking con-

sidering its demographic challenge: Japan is starting to slide down

the reverse slope of an inexorable demographic curve. Forecasts by

the countrys National Institute of Population and Social Security

Research estimate that the number of people between 15 and 64

years old will nearly halve in the next 50 years, to 44.2million in2060 from 81.7million in 2010, even as the number of retirees swells.

Japans public pension system was basically a pay-as-you-go

defined benefit plan until the past decade, when Tokyo created the

GPIF and began a series of incremental reforms designed to put

the countrys pension system on a more sustainable basis, such as

increasing contribution rates and reducing benefits. Those measures

fall well short of whats needed to ensure that the GPIF will be able

to redeem the promises made to todays workers, though. Already,

the fund is paying out more in pension benefits than it receives in

contributions, an inflection point it passed in 2009.

The twin problems of government deficits and demographic

decline have seized center stage in Japans policy debate. All eyes are

on the GPIF and its massive pot of money, to see whether the fundcan generate adequate returns on its portfolio. This debate highlights

several policy trade-offs of deep interest to pension funds, money man-

agers and Treasury and Finance Ministry officials in North America

and Europe, where countries face the same dilemma of demographic

pressures and underfunded pension schemes. How Japan resolves its

debate is bound to shape global financial markets in a profound way.

Hence my trek to see Mitani-san. Why did the GPIF make its

conservative portfolio strategy choice? What political factors got

it there, and what governance structures keep it there? Who makes

money from the GPIFs strategy, and who might profit or lose

from a shift in the funds risk-reward profile? These were just a few

of the questions I hoped to get answers to.

JAPAN IS MY SECOND COUNTRY. I AM PROBABLY ONE

of only a few foreigners who breathe a sigh of comfort after coming

through Narita International Airport. Ive been visiting Japan for four

decades, lived in Tokyo for seven years and met my wife there. The

social clues and nuances, the linguistic indirection and politesse, are

second nature to me now. Tokyo is constantly being rebuilt physi-

cally, but the social infrastructure endures.

Visitors to Japan are struck by how well the physical infrastructure

works. One of my trader friends turned to me after a weeks sojourn

in Tokyo and asked, What part of this lost decades story am I

missing? Japan is supposed to be stuck in a permanent recession,

but the buildings are beautifully designed, traffic flows smoothly,everybody is well dressed and healthy, a Shinkansen [bullet train]

leaves Tokyo Central Station for Osaka every five minutes, and there

are more Michelin three-star restaurants in Tokyo than in Paris.

Hes right. The Michelin three-star count is Tokyo: 14, Paris: ten.

New York, by the way, has just seven.

One of the answers to this conundrum is concealed behind ananonymous gray door in Kasumigaseki, the government quarter of

Tokyo, which lies just south of the Imperial Palace. Kasumigaseki has

been the center of bureaucratic power in Japan for more than a cen-

tury. The Ministry of Finance and the Ministry of Economy, Trade

and Industry practically glare at each other across Sakurada-dori, the

avenue that bisects the district. These two ministries have competed

for sway over Japans economy since the end of World War II.

Once the unquestioned headquarters of Japan Inc., the serried

ranks of ministry buildings in Kasumigaseki are under siege figura-

tively and, since the March 2011 Tohoku earthquake, literally. As I

made my way to the GPIFs offices through a light March drizzle, a

noisy scrum of antinuclear energy demonstrators gathered outsideMETI. The demonstrators placards accused the ministry of flawed

regulation of Japans nuclear power industry. METI was basically

conflicted; it was supposed to be the safety regulator of the very

industry it was nurturing to reduce Japans dependence on imported

oil. The government is similarly conflicted on pensions. It wants

the GPIF to produce good returns, but it also needs to finance its

massive deficit cheaply, which means stuffing ever more Japanese

government bonds, or JGBs, into the pension fund.

Despite the antinuclear protest outside, there was no noise inside

the GPIFs offices, once I finally found them. The pension fund is

tucked away on the second floor of a nondescript building set back

from Sakurada-dori by a small brick plaza featuring one of Tokyos

omnipresent Takarakuji lottery kiosks an ironic scene-setter for avisit to a fund where nobody gambles with money. There isnt even a

receptionist on the second floor. You must ring up your interlocutor

from a phone on the wall of a small vestibule that feels as claustro-

phobic as an airlock. The offices are plain, and the head count is just

75, making the GPIF a seeming paragon of efficiency.

Once I made it inside the funds offices, Mitani and two colleagues

sat down with me, and we were brought the usual cups of green tea.

Thoughtful and gracious, Mitani had a distinguished career at the Bank

of Japan before joining the GPIF in 2010. He was flanked by Takashi

Jimba and Tokihiko Shimizu of the funds research department.

I noticed that Shimizu was holding an annotated copy of my Insti-

tutional Investorarticle on CalPERS (March 2012 Americas edition),

which described how the California pension fund was reaching for

yield in a bid to dig itself out of a funding hole. I was curious what the

three of them made of CalPERSs investment dilemma that was

the principal reason for my visit. They were curious about how Cal-

PERS was rethinking its own strategy. We consider them something

of a peer, said Shimizu. And we follow what they are doing closely.We went back and forth in a mixture of English and Japanese. I

Our basic directive is to safely

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PREVIO

USSPREAD:OLDWOMEN:

TOSHIY

UKIAIZAWA/REUTERS;ALLOTHERS:

TOMOHIROOHSUMI/BLOOMBERG


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wanted to be precise and also to make sure of

my grasp of the financial idiom in Japanese,

so I went back and verified these quotes in a

subsequent e-mail exchange.

The GPIF has adopted a relatively low-risk, low-return portfolio strategy, I noted.

Some analysts say this is proper and prudent,

since the Japanese public has a low prefer-

ence for risk and since Japan has had low real

growth for the past two decades. Others sug-

gest that the GPIF is a long-term investor and

should be able to reap the higher returns from

higher-risk, long-term investments, and that

if you did so, it would reduce the annual pen-

sion contributions from the Japanese govern-

ment budget, which is already under pressure.

Which approach do you agree with?We at the GPIF take our guidance on our

risk-reward portfolio strategy from the minis-

ter, so we dont decide on the risk preference

ourselves, Mitani responded. But in any case,

our basic directive is to safely invest the GPIFs

funds to achieve the necessary long-term

return with the minimum exposure to risk.

THE ANT AND THE GRASSHOPPER

has a remarkably long history in Japan. Intro-

duced by Portuguese Jesuit missionaries,

Aesops fables first appeared in Japanese translation in 1593, and

they remain among the best-known moral texts. Generations ofJapanese children have been taught to identify with the ant who,

unlike the carefree grasshopper, worked hard in the summer to save

up food for the future. That principle has been ingrained in Japans

development philosophy for nearly 150 years. The government has

encouraged savings and channeled that money into the grand project

of modernization and industrialization since the Meiji Restoration.

Aesop, of course, ignored the distributional side of the allegory.

Not so Japans politicians and bureaucrats. For decades they have

used the GPIF and its predecessors as piggy banks to fund ambitious

public works and constituency-pleasing handouts. The financial

return on the pension portfolio was not a big concern.

MoF bureaucrats and Liberal Democratic Party politicians have

at various points in time used pension funds for industrialization,

to finance government debt and to prop up the price of the stock

market, says Gene Park, a scholar of Japanese financial policy and

assistant professor of political science at Loyola Marymount Univer-

sity in Los Angeles. Japanese officials are increasingly aware that the

goal of pension investments should not be to provide patient capitalor public finance but rather to ensure the solvency of the pension

funds themselves. Making this transition, however, has been neither

easy nor fully successful.For most of the postwar period, a large amount of Japans pension

savings was funneled into the MoFs Trust Fund Bureau. Much of

this money disappeared into the now-infamous Fiscal Investment

and Loan Program, or FILP, a sort of huge parallel budget largely

under the control of ministry bureaucrats. Politicians despised the

MoFs tight grasp over the FILP but loved to be the beneficiaries of

investments in their electoral districts. FILP became a source

of funds that the LDP used to respond to the demands of key con-

stituencies and coopt opposition issues, observes Park. Opaque

accounting, minimal oversight and lack of deliberation in the Diet

allowed the funds to be used easily for politically expedient purposes.

The marvelous public infrastructure that my trader buddy so

admired decades later is one of the fruits of the FILP. Airports, high-

speed trains, fiber-optic trunk lines, nuclear reactors you name

it. All fueled by low-cost capital. According to foreign observers

such as my friend Ezra Vogel of Harvard University, who penned

his influential bookJapan as No. 1 in 1979, this was a key feature

of Japans developmental regime: patient capital in the hands of an

invest the GPIFs funds to achieve the necessary long-term return

with the minimum exposure to risk. Takahiro Mitani, Government Pension Investment Fund

Pension financing challenges both Prime Minister Noda (left) and the GPIFs Mitani

MITANI:TOMOHIROOHSUMI/BLOOMBERG;

NODA

:HARUYOSHIYAMAGUCHI/BLOOMBERG

continued on page 72

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efficient bureaucracy and patient capital

in the hands of efficient private enterprise,

joined in a high-growth, low-tax effort. That

was the magic formula.

Patient capital also fueled investment

in the private sector. As a junior banker at

thenChase Manhattans Tokyo branch

in the mid-70s, I was awed by Mitsubishi

Heavy Industries huge shipyards, Japan Steel

Works giant blast furnaces and rolling mills,

NEC Corp.s billion-dollar semiconductor

facilities and Toyota Motor Corp.s gleaming

new assembly plants. I was surprised by howfew of these investments were subjected to any

kind of return-on-capital threshold. Like the

MoF bureaucrats, the insurance companies,

trust banks and so-called city banks providing

the loans didnt waste much time on that sort

of detail back in Japans go-go years.

In retrospect, the countrys much-admired

development regime carried the seeds of its

own stagnation. When I returned to Japan in

the 1980s, working in the integrated-circuit

business, we Silicon Valley guys feared that

NEC, Fujitsu and other Japanese companies

were going to drive us out of business with

their patient capital and technical prowess.

And they did drive Intel Corp. and my one-

time employer, Advanced Micro Devices,

out of the dynamic random access memory

(DRAM) business. We retreated into the

microprocessor and telecommunications

segments, where we could make some money.

When I was in Tokyo in February of this

year, I picked up the morningNikkeiShim-

bunto read about the $5.5billion bankruptcyof Elpida Memory, the last Japanese manu-

facturer of DRAM. Elpida combined thememory operations of NEC, Hitachi and

other Japanese semiconductor majors in a

last-ditch effort to resist South Korean and

Chinese incursions into the market, powered

by South Korean and Chinese patient capital

and technical prowess.Efforts to shift away from the cheap-

capital-development model have led to a

decadelong tug-of-war between the bureau-

crats and the politicians, with pension funds

very much at the heart of the struggle. The

LDP wrenched partial control of pensions

away from the MoFs Trust Fund Bureau

and FILP in the 1990s, placing some funds

under the purview of the Ministry of Health,

Labor and Welfare. The Korosho, as the

Labor Ministry is commonly known, put the

money to work in Japanese equities and, to alesser degree, real estate. These first experi-

ments in diversification produced some nega-

tive results as funds were hammered by the

meltdown of the Japanese stock and property

markets in the 90s. But the LDP persevered,

finally pulling the entire pension fund away

from the MoF in 2001 and establishing the

first iteration of the GPIF. This was one pillar

of several epic reforms begun by former prime

minister Ryutaro Hashimoto in the late 90s

and pushed through early in the 2000s by

former prime minister Junichiro Koizumi.

Koizumi succeeded in a high-stakes gam-ble that included a successful referendum on

his reforms, but he made some compromises

with the LDP old guard and the MoF along

the way. The GPIF promised to continue to

stream funds into the FILP for seven years.

And the Korosho put together an expert

advisory committee to set the GPIFs port-

folio strategy. No surprise: Most of the funds

were more or less earmarked to finance the

government, a choice thats still reflected in

the GPIFs portfolio today.

Yet the GPIF did cautiously edge awayfrom its home-country bias a predilection

common to almost all national pension plans

and carefully began investing in foreign

equities and fixed-income securities. These

investments were invariably hurt by periodic

yen revaluations against foreign currencies,

particularly the dollar. The GPIF still bears

the scars from its first attempts at climbing

out onto the yield curve from the safe base of

JGBs. So do most Japanese citizens.

The foreign financial press often describes

the caution of the prototypical Japanese

everywoman saver, Mrs. Watanabe, sincethe bursting of the countrys financial bubble

in the 90s, and they are not far off on this. My

Japanese mother-in-law parlayed a modest

nest egg into a small fortune by playing the

stock market and reinvesting profits in Tokyo

real estate. She followed the Nikkei closelyand was an awesome stock picker. A famous

beauty in her youth, she charmed several

generations of branch chiefs at Nomura

Securities in Denenchofu, the tony Tokyo

suburb where she lived.

In the 1980s, when I was working in Sili-

con Valley and managing Advanced Micro

Devices Japan, she used to quiz me about the

prospects of various technology companies,

their stock prices circled in red pencil on

her dailyNikkei. But her ventures in foreign

stocks were disappointing as yen apprecia-tion clobbered her returns. She gave up on

foreign stocks in the mid-1990s.

THE GOVERNANCE STRUCTURE OF

Japans public pension system is a triangle.

The Korosho sits at the apex. The ministry

decides benefit and contribution levels, and

sets risk and return targets for the GPIF. The

fund, in turn, determines its strategic asset

allocation, but it entrusts most of the actual

money management to outside firms.

The purpose of this governance struc-

ture was to devolve responsibility for invest-ment management from the Korosho, which

was apt to be the target of political criticism,

explains Masaharu Usuki, a Nagoya Uni-

versity economics professor who sits on the

GPIF investment committee. As a result,

Japans pension system was less vulnerable to

reputation risk and political criticism during

the market turmoil of 200809 than it was

during the turmoil of 200002.

According to Yuji Kage, former chief

investment officer of Japans Pension Fund

Association: The Korosho reviews and recal-culates the long-term forecast of the financial

condition, the assets versus liabilities, of the

public pension fund every five years. In doing

so, another government committee of econ-

omists provides their forecast of economic

parameters, including the rate of long-term

investment return, which in turn is used as an

assumption for actuarial purposes. Kage was

careful to remind me that his comments are

strictly his personal observations.

Although the Korosho holds most of the

cards, the asset allocation process has seen

some modest devolution of authority tothe GPIF, with the fund given discretion to

THE ANT, THEGRASSHOPPERAND THE WIDOW-MAKER TRADEcontinued from page 45

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set parameter values for each asset classs

expected return and risk, and to select asset

classes for investment, says Nagoyas Usuki.

Yet many outside observers believe the

fund is excessively constrained by its Koro-sho masters. In a 2010 working paper, econ-

omists at the Organization for Economic

Cooperation and Development contended

that the GPIFs structure and investment

strategy did not comply with the OECDs

principles for public pension management.

The GPIF decision making is limited to

what has been authorized by the Minister

in charge i.e. it is not a fully independent,

segregated entity, wrote Fiona Stewart and

Juan Yermo, members of the OECDs finan-

cial affairs division. The governance struc-ture of the fund may therefore encourage its

low profile, seemingly low risk, conservative

nature, which may not be addressing risks

fully and certainly means that the potential

of the institution is under-utilized.

Not only does the GPIF have limited dis-

cretion in altering the portfolios risk budget,

its capacity to manage the funds is severely

limited by statute. In their zeal to avoid

bureaucratic empire-building, Japans pen-

sion reformers strictly limited the size and

compensation levels of the GPIF, forcing it

to outsource the management of 90 percent

of its market investments.

Keith Ambachtsheer, director of the Uni-

versity of Torontos Rotman International

Center for Pension Management, thinks this

strategic choice is suboptimal. The invest-

ment mandate, as well as the organization

and governance structure chosen for GPIF,

drives it toward a cost- and risk-minimizing

culture, he says. In contrast, countries

such as Australia, Canada, New Zealand

and Sweden have chosen mandates that are

driving their national reserve funds toward

high-performance cultures, marked by

organizational independence, expert inter-

nal investment and control capabilities, andperformance-based compensation schemes.

Ambachtsheer goes on to adumbrate the

benefits of the high-performance approach.

A return increase of 2 percent per annum

would increase Japans public pension

reserves by a highly material 1.6trillionper year, he says. Japan has built a justified

global excellence reputation in the design

and manufacture of consumer products.

Why not in fund management too?

Economies of scale was a concept that had

been drummed into me during my years in

Silicon Valley. Potential scale economies are

even more breathtaking in finance. Entities

like the Canada Pension Plan Investment

Board, as well as Dutch and Scandinavian

pension plans, have demonstrated as much,

earning great reputations for competentand cost-effective fund management. So I

took another sip of green tea and carefully

assembled another question for Mitani:

Some foreign pension funds are bringing

some asset management functions, such as

passive equity investments, in-house because

of economies of scale. With its huge size,

the GPIF has even more potential econo-

mies of scale if it performed more in-house

asset management. Are the Korosho and

the GPIF firmly committed to the current

low-cost, low-risk management approach?

We do some in-house passive manage-

ment of Japanese bonds, but we dont cur-

rently do in-house management of foreignbonds because of lack of organizational

skills and also because of operating budget

constraints, said Mitani. As for domestic

and foreign stocks, we are not permitted

to actively manage these assets by the pen-

sion law statutes. Overall we are required to

achieve the policy goals given to us by the

ministry with minimum risk and maximum

return while minimizing expenses.

Mitanis operation is low-cost, for sure.

The GPIF paid a total of 24.6billion inmanagement fees in the fiscal year ended

March 31, 2011 an astonishingly slim0.02 percent of fund assets. It spent 0.01

percent on the management of Japanese

bonds, 0.05 percent on the management

of both domestic and foreign equities, and

0.06 percent on international bonds. Mitani

is running exactly the kind of lean operationthat the Korosho wants. And it requires him

to depend on outside money managers.

At the end of March 2011, the GPIF

staff ran a total of 9.8trillion in two in-house domestic bond funds, 2.9trillionof near cash-equivalent short-term assets

and 18.2trillion of FILP bonds. The fundoutsourced management of the remain-

ing 85.4trillion of assets to 28 externalmanagers. The externals included a dozen

of Japans largest managers, led by Sumi-

tomo Trust & Banking Co. and Chuo MitsuiAsset Trust & Banking Co., and a virtual

whos who of big Western outfits mostly

U.S.-based such as BlackRock, Goldman

Sachs Asset Management and State Street

Global Advisors.

While it is possible that we could

decrease external management fees by

bringing more of the management of

Japanese bonds in-house, we are limited

in doing so by factors including possible

market impacts of the sheer size of our asset

holdings, concentrated operational risk and

operational budget constraints on the GPIFitself, said Mitani. The GPIFs midterm

policy guidance requires us to carefully

consider transactions and market scale so

as to avoid major market dislocation, price

distortion or excessive concentration. So

we move very carefully when rebalancing

our portfolio, in order to avoid these kinds of

market dislocations or distortions.

Kage agrees with this cautious assess-

ment. Even a 1 percent change in allocation

means a transaction of about $14billion,he notes. So its impractical for GPIF toconsider the same active investment strategy

as funds with $200billion to $300billion.Indeed, size is a major obstacle to accom-

plishing more-effective investment.

The GPIFs return benchmark is a bit

unusual for a pension fund: The Koroshos

guidance calls on the fund to beat Japans

annual growth in nominal wages by 1.1 per-

centage points. By this measure, the fund did

pretty well until quite recently. For the eight

years up until 2010, the GPIF produced

an average annual return of 2.43 percent,

while wages declined at an annual rate of0.55 percent welcome to Japans second

The governance structure of the fundmay encourage its conservative nature,which may not be addressing risksfully and means that the potential ofthe institution is under-utilized. Fiona Stewart and Juan Yermo,OECD



lost decade. So the fund beat its benchmark

by almost 200 basis points a year.

But in the fiscal year ended March 31,

2011, Mitani and his colleagues had a return

of 0.25 percent. The portfolio took hitsof 9.04 percent on its holdings of Japanese

stocks and 7.06 percent on foreign bonds,

while domestic bonds were up 1.95 percent

and foreign stocks gained 2.18 percent.

From April through December 2011, the

latest figures available, the overall portfolio

was down by 2.54 percent. A gain of 2.58

percent in domestic bonds was more than

washed out by declines of 15.12 percent on

domestic stocks, 16.01 percent on foreign

stocks and 4.39 percent on foreign bonds.

Many economists like the idea of target-ing returns to nominal wages, asserting that

in the long run it is unrealistic to expect

returns on financial investments to exceed

the underlying growth rate of the economy.

But many financial professionals are taken

aback by the unusual benchmark.

While actuarially speaking, such a long-

term goal makes sense, from the perspective of

an investment manager such a target needs to

be translated into returns that can be obtained

from market instruments, the OECDs Stew-

art and Yermo wrote in their report. GPIF

cannot be evaluated for missing a target that isultimately outside its control (wage growth).

Yet the OECDs criticism may miss a

more important public policy point. By using

real wages as a benchmark, the Korosho and

the GPIF are avoiding the kind of unrealistic

targets that have led so many other public

pension funds into wishful-thinking terri-

tory. A recent survey by Wilshire Associates

showed the average U.S. public pension fund

had a target return that was at least 1 percent-

age point above realistic expectations.

Indeed, for skeptics of the so-called Yale

model of reaching for yield, currently fol-

lowed by most U.S. public pension funds, the

GPIF is an admirable example of a liability-

driven investment, or LDI, approach to pen-sion fund management. The LDI catechism

states that the risk, return and maturity pro-

file of the pension funds assets should match

the risk, return and maturity profile of its

liabilities. Because Japanese retirees claims

are known with actuarial precision, an LDIadvocate would argue that the GPIF should

fund these claims with an amount of JGBs

or other risk-free assets that matches the

maturity of these future pension obligations.

Kage makes a strong case for the GPIFs

conservative strategy. So long as public

funds ultimately are governed by the govern-

ment, which is controlled by representatives

of the general public, risk tolerance is subject

to the general publics risk tolerance, and the

general publics risk tolerance is not neces-

sarily high, he explains. If and when thestock market collapses and performance

goes negative for some time, people, the

media and politicians will complain loudly.

For sure, both the archetypal Mrs. Wata-

nabe and my real-world mother-in-law have

a low tolerance for volatility at this point.

If it were explained to them in common-

sense terms, theyd probably concur with

the GPIFs conservative strategy.

But is there another, deeper risk buried

inside the GPIF portfolio?

Kyle Bass of Hayman Capital Manage-

ment thinks so. A vocal JGB bear, Basscompared Japans fiscal situation to Bernie

Madoffs Ponzi scheme, speaking at the Uni-

versity of Virginia Investing Conference in

November 2011. You dont have to live

up to any of the promises that you make as

a government or as an investment manager

as long as you continue to have more people

entering your scheme rather than exiting,

he said. Thats no longer the case in Japan,

he noted. The population is in a state of

inexorable decline. And what that means

is that you will begin to have more people

dissaving than saving. Thats an ominous

development for a government that needs

to sell bonds to banks, insurers and pension

funds to finance its massive deficit.The scale of Japans government debt is

huge. According to estimates by Torsten

Slok, an economist at Deutsche Bank, the

MoF will issue bonds in the amount of nearly

60 percent of GDP this year to finance the

deficit and roll over maturing debt.If Bass is right, the GPIF is exposed to a

huge capital gains risk on its JGB portfolio. A

couple of basis points uptick in the rates that

the government must pay on its mountain of

debt ten-year JGBs were yielding just 0.83

percent last month would blow a huge

hole in the MoFs annual budget.

I queried Mitani about this in our follow-

up e-mail exchange: Some analysts suggest

that with Japanese government debt growing

above 200 percent of GDP there will be a

crossover point, called X-day, when the yieldon JGBs will increase suddenly, causing large

losses for holders of JGBs, such as the GPIF.

A recentAsahi Shimbunreport said that Mit-

subishi-UFJ was planning for a 2016 X-day

contingency. What steps have the GPIF and

the ministry taken to insulate the savings of

Japanese pensioners from the potential port-

folio losses of an X-day-type event?

The fund president didnt seem too con-

cerned. Generally speaking, a sudden rise in

JGB interest rates would cause GPIF a capital

loss, he responded in an e-mail. On the other

hand, higher yields on the JGB portfolio wouldincrease our current income. Either way, it

wont change our basic portfolio strategy.

By contrast, the critical OECD authors,

Stewart and Yermo, took the GPIF to task

over this issue. Is the GPIF really consider-

ing the risk which its huge holding of JGBs

represents, which the OECD considers real

given the rising level of public sector debt

even with the countrys strong home bias

and domestic funding ability, or is it just

assuming that this is a low-risk portfolio?

they wrote in their report.Financial professionals in Tokyo and

around the world see a JGB interest rate

inflection point coming sooner or later.

According to one Hong Kongbased trader

friend of mine: Its not a matter of if . Its

a matter of when. That said, shorting the

JGB market is also referred to sometimes as

a widow-maker trade.

The worlds trading flows are strewn

with the bodies of traders who have made

that bet and lost it again and again, says

Thomas McGlade, head of U.S. operations

at London-based hedge fund firm PrologueCapital. As Hemingway famously wrote, a

The population is in a state ofinexorable decline. And what thatmeans is that you will begin to havemore people dissaving than saving. Kyle Bass, Hayman Capital Management

74/JAPAN


8/8I N S T I T U T I O N A L I N V E S T O R . C O M J U LY / A U G U S T 2 0 1 2

man goes broke slowly, and then all at once.

Japan is clearly going broke slowly, but we are

not currently at, and may be years away from,

Japans all at once moment.

Japans grim fiscal outlook is deeplyentwined with its pension fund management

problem. The money to fund the govern-

ments deficit, pick up its share of pension

benefits and pay interest on the JGBs already

stashed inside the pension fund all comes

from the same tax pot.

Every time a new prime minister is

selected in Tokyo, there is a fierce battle for

his soul. On one side hand-wringing MoF

mandarins tell him that without an increase

in revenue and control over expenses, the

budget is busted and X-day looms ever

closer. They usually propose an increase

in the consumption tax to plug the gap. On

the other side the prime ministers advisers

tell him that a consumption tax increase istantamount to political hara-kiri. For the

moment, the mandarins have convinced

Prime Minister Yoshihiko Noda of the wis-

dom of doubling the consumption tax, to 10

percent, to fund the pension system. Ichiro

Ozawa, a key power broker in Nodas Demo-

cratic Party of Japan, and other rivals in the

Diet are maneuvering to bring the prime

minister down on precisely this issue. The

consumption taxpension funding problem

may have become, like Social Security in the

U.S., a high-voltage political third rail.

Potential fiscal policy changes may drive

future public pension fund reform, says

former pension group CIO Kage. Japanese

government debt is approaching 200 percent

of GDP, and although Japans interest rates

are the lowest in the world, this situation will

not continue forever. Inevitably, the gov-

ernment will start to consider changing its

policy, expecting a higher return on public

pension fund assets in order to reduce the

government budgetary support.

A pension fund trustee has some hard

choices. In the case of a private defined ben-efit plan, trustees may choose to prioritize

plan beneficiaries and reach for yield if they

can put the downside risk of volatility

back to the plan sponsor. If they lean instead

toward the sponsor, the trustees will want

to minimize the plans exposure to volatilityby either funding it fully with low-risk assets

(which is expensive) or converting it from

defined benefit to defined contribution.

For a national public defined benefit plan

like the GPIF, there is no real choice. The

trustees could prioritize beneficiaries and

go for yield, putting the volatility risk to the

government, but that would only be an illu-

sion. The risk ultimately ends up in the lap

of the taxpayer, who has to fund the plan and

plug any gaps caused by volatility.

This dilemma raises a nettlesome ques-

tion: To whom does the GPIF board owe its

fiduciary responsibility pension beneficia-

ries or Japanese citizens as a whole?

If ensuring higher risk-adjusted returnswere its prime mission, the GPIF would start

to invest more heavily in offshore equities,

particularly in emerging markets, as well as

in other high-yielding assets to maximize

returns and absorb the volatility that comes

with that territory. But this portfolio adjust-

ment would force the Japanese government

to pay higher rates on its debt; that means it

would have to tax its citizens more and go

even further into debt, placing more of a

burden on future citizens.

Who exactly is responsible for the futurepayment of benefits? says Kage. Those

who make the promise today may not be the

people to actually deliver on the promise in

future decades. It is much easier to make a

promise that somebody else is supposed to

carry out. Here the future generation is not

in a position to sign the contract at all. This

is the critical agency problem.

THE DAY AFTER I CALLED ON

Mitani at the GPIF, I visited my mother-in-

law at her new assisted-retirement home,

the Wellina O-Okayama. I was still tryingto figure out whether the GPIF was a struc-

tural defect or a structural advantage for the

management of Japans economy, and how

that translated into the optimum portfolio

strategy for the funds 108trillion in assets.Looking up from my notes, I realized how

old everyone on the train looked (although

maybe I was just projecting my own preoc-

cupations onto the passengers). Old, yes, but

well dressed. Almost all of them were either

napping or texting on their cell phones. And

some of the ladies my age looked exception-

ally well put together.

My mother-in-law is 90 frail but sharp

as a tack. She is pleased to be in the Wellina,

recently built by Tokyu Group across the

street from its O-Okayama hospital. As I left

her room, I noticed a copy of that morningsNikkeinewspaper next to her pillbox, with

something circled in red.

The Wellina is beautifully designed, with

wood-paneled hallways, a lovely garden and

a relentlessly pleasant staff of caregivers,

many of them retired personnel from Japan

Airlines Co. I was so impressed that I told the

reception staff on my way out that Id like to

make a reservation for my wife and me to

move into the Wellina in March 2032.

They seemed to find that very funny.

But I was serious. There are few better

places in the world to grow really old in thanJapan. Both the physical and the social infra-

structure are wonderful. Im sure the staff

will be indulgent with the cranky old Ameri-

can with his cane and foreign accent. In any

case, my oldest son is a physician in Tokyo

and will keep me on my meds. And may even

help me cash my retirement checks.

In this sense, the Japanese are way ahead

of us all in planning for the realities of aging,

just as they have encountered the hard edge

of deflation and demographic reversion

before the rest of the developed world. Lets

hope they figure out how to solve the pension

strategy conundrum too. Because were all

headed down the same road.

James Shinn ([email protected] ) is a lec-

turer at Princeton Universitys School of Engi-

neering and Applied Science. After careers on

Wall Street and in Silicon Valley, he served as the

national intelligence officer for East Asia at the

Central Intelligence Agency and then as assistant

secretary of Defense for Asia at the Pentagon. He

is chairman of Teneo Intelligence and serves on

the advisory boards of Oxford Analytica andCQS, a London-based hedge fund.

Inevitably, the government willconsider

changing its policy, expecting a higherreturn on public pension fund assets inorder to reduce budgetary support. Yuji Kage, former CIO, Pension Fund Association

Documents

GPIF - Ant, Grasshopper and Widowmaker