Pensions are not Investments

They are instead a form of insurance

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I was getting ready to talk to a client yesterday when I had a thought: state or defined benefit pensions are a kind of insurance, not an investment like many people assume.

A defined benefit pension promises you a specific amount of money, unlike a defined contribution pension (like iDeCo) that will give you different results based on market returns.

Even I fell into this trap, analysing the benefits of going back and topping up partial payments to kokumin nenkin in terms of the expected investment return.

​In some ways it may be best to think about defined benefit pensions by looking at something very similar: an annuity.

​There are different types of annuities. Generally speaking, you should avoid variable annuities (complex, high/opaque fees/no guaranteed payouts) and instead go for simple annuities.

A simple annuity is a financial product that allows you to purchase a lifetime income from an insurance company. The company will use its actuaries to calculate your expected lifespan and adjust rates so that they can make a profit.

Generally speaking, the following options make annuities more expensive:

1. if they are index-linked (go up with inflation)
2. the younger you are when they start
3. if they start immediately
4. if they can be transferred to your spouse

The main disadvantage of an annuity over investing yourself is that if you die earlier than expected the insurance company keeps the money.

The advantage is that (as long as the insurer remains in business) you will never run out of money or end up destitute.

Current annuity rates in the UK seem to be about 4% for a 55-year old and up to 7% for a 75-year old.

Compared to this national pension schemes seem like a pretty good deal. For kokumin nenkin, you pay 16,000 yen a month for forty years, and the government then pays you 65,000 yen a month for the rest of your life. Your total contribution is approximately 7.7 million yen. You would ‘make it back’ in just under ten years. To put it another way, to buy an equivalent annuity in the UK would cost you almost twice as much.

The purpose of a defined benefit pension is not to maximise your investment returns, but rather to insure yourself against outliving your investments or your ability to manage them. Ideally it should create a bare minimum income floor that protects you from poverty. You can then use other investments to add a bit of comfort and luxury to your life.

If you are a resident of Japan and not currently paying into the Japanese pension scheme, it might be worth reconsidering that decision, particularly if you are not going to receive any other kind of defined benefit pension.

What do you think? Do you have plans to buy an annuity? Are you paying into any pension schemes?

10 Responses

  1. I’m buying into the pension as it’s a social responsibility and I do believe in society taking care of one another so would be a hypocrite not to pay into it.
    I do hope it stays afloat and see it as something that would be “nice” to get after retirement but I’m still dubious about whether or not we will get anywhere near what is stated now, and am counting more on NISA/personal investments for my own retirement.

  2. Nice summary thanks.
    I would add that, if you are a company owner or director, you are entitled to a fixed amount of tax free cash for retirement based on the number of years you are in business. In my case, after 18 years, the amount is 7.2 million yen. You need to take it as a lump sum payment, so your company must have the cash. You must also own less than 50% of the company after retirement and your salary must be 50% of your salary before your retirement. I think this is much preferred to the annuities offered in Japan. Basically, the tax savings (20% or so for long term capital gains) acts as a kind of interest on the money paid. It’s difficult these days to get 20% on any investment, but fairly easy to create your own company.

  3. I started paying 16,000 yen a month towards the Japanese pension about 3 years ago. On advice from my wife I increased this to 30,000 yen. Do you think this was a wise move?

      2. My pleasure! I think it can make sense to pay into nenkin kikin in some situations (the alternative would be iDeCo), but I definitely recommend saving and investing alongside it.

  4. “If you are a resident of Japan and not currently paying into the Japanese pension scheme, it might be worth reconsidering that decision,”
    I second this. For a US citizen, I was pretty bummed, I thought you could only collect one or the other, nenkin or social security. To be fair it is true, you can only collect one, BUT if you move back to the USA your nenkin payments, due to tax treaties, get figured into social security. Its not 1:1 or 100% of what you would get in Japan, but a fair does going into figuring your ss if you move back.

    1. Interesting. I think property tax is fairer than council tax, but unless we return to the UK none of that will affect us.