Japan and South Korea are aging rapidly. According to the Korea Times, the median age of South Koreans will increase from 40.8 years in 2016 to 52.6 years by 2040. The percentage of the Japanese population over the age of 65 is slated to increase from 25 percent in 2017 to 40 percent by 2060. Aging populations will have far-reaching economic consequences for both Japan and South Korea. From a macroeconomic perspective, as retirees start using their pensions, national savings in both of these nations will decrease. Decreases to national savings correspond to decreased investment, and as investment decreases, sustained economic growth becomes more difficult to ensure. As economic growth slows, an important question emerges – how can these societies ensure current and future generations will have enough money for retirement?
The historical asset allocation of the National Pension Service of South Korea (NPS) illustrates a strong aversion to risk. According to Sung-Yun Han, who was the Head of the Pension Fund Policy Team at the National Pension Research Center in 2002, 90.9% of the NPS’s assets at the time were invested in bonds. In 2013, the percentage of the NPS’s assets invested in bonds decreased to 64.8% percent. Although the allocation to fixed-income securities has decreased over time, Professor Inmoo Lee of KAIST Business School argues that, in absolute terms, the Korean NPS still has a much larger percentage of its assets invested in bonds than other comparable public pension funds.
An analysis of the Japanese Government Pension Investment Fund (GPIF) tells a similar story. In early 2014, 60% of the GPIF’s assets were invested in Japanese Government Bonds. However, on October 31, 2014, the GPIF made radical changes to its portfolio. Prompted by the economic recovery plan championed by Japanese Prime Minister Shinzo Abe, the GPIF decided to decrease holdings of domestic bonds from 60% to 35% and increase holdings of domestic and foreign equities from 12% each to 25% each. This change represents a challenge to the risk averse mindset that has historically dominated Japanese financial markets. More importantly, it is a meaningful step towards ensuring the GPIF will remain solvent in the years to come.
Why is risk aversion problematic for these pension funds? Lower risk fixed-income securities, such as government bonds, offer lower returns than individual equities, mutual funds, and other types of alternative investments. Given that South Korea and Japan are facing major demographic pressures, the returns that majority fixed-income portfolios can provide their government pension funds are simply not high enough to ensure that they will be able to meet their obligations in the long run. In order to keep pace with the growing financial needs of their retirees, the GPIF and NPS will have to demonstrate a sustained commitment to more balanced portfolios that take on more risk, and by definition, offer higher upside.
Taking on this risk averse mindset will not be an easy task. According to Bloomberg, as of 2012, 844 trillion yen, “almost twice [Japan’s] yearly economic output, sits idle in cash at home and in savings accounts earning 0.02 percent.” Japanese asset management professional Ichiro Suzuki attributes some of this risk aversion to the hard lessons learned during the 1997 Asian Financial Crisis. The stock market declines, losses in household wealth, and economic stagnation realized during that time convinced a number of Japanese citizens to lose faith in the financial system as a whole. The sheer volume of wealth kept in cash and savings accounts shows that the distrust has remained a potent force ever since. Given that the consequences of the Asian Financial Crisis were equally, if not more severe for South Korea, Mr. Suzuki’s argument can be used to explain some of South Korea’s risk aversion as well. The conclusion is simple – making lasting changes to the asset allocation decisions of these pension funds will require combating deeply ingrained societal trends.
Diving more deeply into the issue of asset allocation, a reasonable question emerges: if the Japanese and Korean pension funds need to make riskier investments, what should they invest in? The age of realizing massive gains through manual “stock picking” has come and gone. Investment professionals at Evolution Financial Group, a multinational financial services firm that has operated in Japan for more than a decade, believe the advent of high frequency trading has made manually profiting off observed discrepancies in the market significantly more difficult, if not impossible. Analysts at Meritz Securities, one of South Korea’s largest securities brokers, have come to a similar conclusion. In the age of information, the lessons of the efficient market hypothesis are more important than ever before – the speed with which relevant information is being priced into the market is only getting faster over time.
Some argue that pension funds such as the GPIF and NPS should invest in passive index funds. Citing the efficient market hypothesis, they argue that this strategy gives investors the opportunity to realize the largest gains over the longest time span. Furthermore, they maintain that passive funds are significantly cheaper than their active counterparts.
However, analysts at Dimensional Fund Advisors (DFA) follow a different approach. This approach – known as factor investing – maintains that certain subsets of the market have higher expected returns than the market as a whole. This approach has been extremely successful for the firm thus far. Whereas only 15% of the industry’s equity and fixed-income funds outperformed an industry benchmark between 2000 and 2015, over 82% of DFA’s equity and fixed-income funds beat the same industry benchmark over that period. The returns that DFA has generated so far show that factor investing has the potential to revolutionize investment philosophies across the world. Whether the GPIF and the NPS choose to invest in passive index funds or actively managed funds, it is clear they have a wide variety of equity based products to choose from.
Not only can these pension funds choose from equity based products, but they can also choose from a number of alternative investments. Yusuke Wantanabe of the Carlyle Group, the world’s largest private equity firm, believes the GPIF will soon begin allocating capital to private equity firms. Despite broader questions of economic stagnation, there are major opportunities for growth in the Japanese private equity industry. Analysts at the Carlyle Group believe Japanese companies will participate in an increasing number of divestitures in the years to come, a potentially lucrative source of deal flow that could provide attractive returns to the GPIF. If the GPIF chooses to invest in private equity funds, then the NPS could follow suit.
The decisions the GPIF and NPS make concerning asset allocation will have ramifications for the retirement possibilities for millions of people across Northeast Asia. As demographic pressures swell, and returns from lower risk fixed-income products prove to be insufficient to meet looming obligations, these pension funds will have to conquer ingrained risk aversion. They will have to invest in equity based products and consider alternative investments such as private equity funds. Moving forward, the next question to consider is what consequence will the decisions of these massive institutional investors have on the growing number of retail investors in these markets.