Korea's pension explosion

 

Korean officials are looking for ways to break with the old, and move in a new direction. The government has incorporated changes in its tax code that could nearly triple the assets in its five-year-old second pillar by the end of this year to KRW40trn ($32bn) from KRW14trn at the end of 2009. Officials also hope encouraging savings in the second pillar will ease the burden on the country’s social security system, which is feeling the strain of increasing life expectancy. 

The government is attempting to shift companies from an old severance pay pension system to pre-funded corporate pension plans by lifting at the end of this year the relief on the 24.4% corporate tax enjoyed by the funded portion of the severance pay arrangements. The forecasts were included in the Korea Pension Report – Providers and Performance, which was published this year by the Seoul office of consultancy Towers Watson.

Korea’s corporate system was introduced in December 2005 and it has since grown both in terms of adoption and by allocated assets.

“It was a bit of a slow burn but the assets have grown at a steady pace for a while,” said Towers Watson’s director of investment services – Korea, Jayne Bok. “It started to gain momentum in 2009 and we polled the market for estimates of how quickly it would grow. There was a pretty wide range of numbers being thrown about – between KRW20trn and KRW40trn – so we took an end-of-the-range figure for the report. But assets doubled last year and if we assume the same happens this year then it takes the total to about KRW30trn, somewhere in middle of that KRW20trn to KRW40trn range, which seems sensible.”

 

Historical significance

The severance pay system, which functioned as Korea’s second pillar, has been mandatory for firms with more than four employees since 1961. Since the late 1970s insurance companies have offered retirement insurance products to those companies that chose to fund part of their liabilities rather than carry them on their books. Tax breaks on the funded portion were offered from 1994.

Meanwhile, in 1988 the state launched a first pillar for private sector workers, creating the partly funded defined benefit National Pension System (NPS) to extend benefits previously only offered to public sector employees.

But later developments dealt body blows to both pillars. Flaws in the severance pay system were exposed when South Korea was caught up in the Asian financial crisis that gripped the region’s so-called tiger economies in 1997.

“By the Asia financial crisis the liabilities of the mandated severance pay plans totalled about $20bn,” said Mercer Korea’s business leader – retirement, risk & finance consulting, CJ Kim. “But only 25% was funded. Many companies went under and lots of people did not get their promised pension.”

“Some of that liability was partially financed through various government insurance programmes but most of the employees lost their benefits,” added Bok. “So to prevent that happening again and to protect the workforce at large it was recognised that pension reform was necessary.”

Foreign as well as domestic advice was sought. “I was first contacted in the late 1990s by some experts in the Korean pension community who had contacts with Swiss institutions like the Swiss Institute for Social Security,” said Swiss-based pensions expert, Werner Nussbaum. During a subsequent two-year attachment in Seoul, Nussbaum produced reports for the public finance department, the department of social welfare and the department for the development of Korean women. “Korea recovered from the Asia crisis very rapidly and much faster than many other members of the OECD (Organisation for Economic Co-Operation and Development); it was a transitory setback,” he noted. “The permanent problem is the gap between the generations.”

 

Challenges

South Korea’s worsening demographic challenge poses a massive threat to the NPS. Its dependency ratio is predicted to change more rapidly than that of any other OECD country. According to Allianz Global Investors estimates, between the 1960s and 2005 South Korea’s fertility rate dropped to 1.2 from 6.0 while life expectancy rose to 77 years from 55. Meanwhile, at around 13%, the proportion of elderly people is currently one of the lowest in the OECD, but it will be among the highest by 2050 at 64%. 

A 2008 parametric reform saw a reduction in the NPS replacement ratio for those qualifying for full benefits after working 40 years to 40% from 60% and a phased in rise in the retirement age to 65 from 60. 

But it is still not enough to make the system sustainable. “Last year the NPS had about $250bn and it will continue to grow to about $1trn,” said Kim. “But then in a relatively short period it will all disappear because there will be so many retirees and Korea will not have enough workers to replenish it.”

It is within this context that in 2003 the government decided to develop a sustainable second pillar by moving to a corporate pension system. Legislation laying the basis for the transformation, the Employee Retirement Security Act (ERSA), was passed in 2005. It allows companies to convert their severance pay plan into a corporate pension, either defined benefit (DB) or, for the first time in Korea, defined contribution (DC). But it is voluntary.

“The regulators had wanted to make it mandatory but then got cold feet,” said Towers Watson’s Bok. “So instead of requiring that everybody move to the new system they left it open-ended and tried the tax incentives to get people to conform.”

But there has been resistance. “Many corporations realised that whether to get a corporate tax write-off when making a vast contribution to fully fund their liabilities or spreading it out over the years from a book reserve system was just a question of timing,” said Kim. “And by 2009 when the global financial troubles affected Korea, corporations preferred to hoard cash rather than pump it into a pension system.” 

As a result the adoption rate is not as robust as the government had hoped. Government data from June 2010 show that only 5.5% of corporations had adopted ERSA, although some 39% of the larger companies had, Kim added.

Similarly, although there are more DC plans, DB, which the trade unions prefer, is the dominant form of corporate pension, with some KRW12.8trn in DB plans and a little over KRW3.8trn in DC. 

“Foreign companies prefer DC,” noted Hewitt Associates’ head of retirement and benefits consulting in Seoul, Austin Kweon. “They have a different objective. They want to align all the pension programmes in the countries where they operate and to make their Korean pension plan more consistent with those in other countries.”

The switch will not mean a difference in contribution level. Under the ERSA, employer contributions to DB plans, like the severance pay option they replace, must amount to at least a month’s final salary for each year of service, and for DC plans must equal at least one-twelfth of a total annual salary. “The new system sets a minimum level of accruals in DB and a minimum level of contributions in DC, and the amounts are pretty similar,” said Kweon. “So if all other conditions are the same, the impact will be the same for employees and the employer. And because the minimum level is pretty high, one month’s pay, this is the most popular level because not many companies are willing to pay more benefit than the legal minimum, and at that level they don’t see any difference between DB and DC.”

But why the expectations of a rapid growth in assets in the corporate funds this year? 

“The tax benefits companies could enjoy under the severance pay system are to be retired as of December 2010 and will now only apply to the new schemes,” explained Bok. “So there is slightly more incentive for employers to transfer to the new system. While that doesn’t necessarily mean there will be an immediate transition, it does give employers a reason to at least look into making a change prior to 2011 and that’s what we are seeing now. There’s a lot of activity in terms of exploring plan design options and talking to vendors and employers in general trying to get their heads around what they are going to do with the intention of doing something this year or next.”