South Korea
compiled by Allianz Global Investors
Pension System Design
South Korea’s pension system has taken shape in the last two decades. In 1988, the state-run National Pension System was established, covering workers in the private sector. Before it was introduced, public pensions covered only government employees, private school teachers and military personnel, and these schemes still exist today. Traditionally, employees in the private sector have been covered by the severance pay system, which has been mandatory for firms with more than four employees since 1961. It provides employees with certain entitlements when they leave the company. In 2005, the legislative foundations were laid to transform the severance pay system into a funded corporate pension system. The new corporate pension system is currently in the start-up phase. Tax-favoured private pension plans have been available in South Korea since 1994.
Apart from the reform of the corporate pension system, the National Pension System is also undergoing reforms. 2008 will see the introduction of a basic pension pillar, which will aim to provide means-tested retirement benefits to combat poverty among the elderly. Contribution rates are also set to rise.
South Korea faces one of the most severe demographic challenges in the world. Today’s dependency ratio stands at 13%. It is expected to rise to 64% by 2050. The total population is expected to peak at around 50 million in 2020 and decline by about 15% until mid-century. The dependency ratio in South Korea is changing faster than in any other OECD country. While the proportion of elderly people is currently the second lowest in the OECD, it will be among the highest by 2050. This demographic pattern can mainly be explained by the fact that South Korea has rapidly transformed from an agricultural to an industrial and urban society. In the 1960s, 28% of the population lived in urban areas. In 2005, that figure had risen to slightly over 80%. This transformation had a noticeable impact on fertility. From the 1960s to 2005, Korea’s fertility rate dropped from 6.0 to 1.2. The current fertility rate is far below the rate of 2.1 children per woman required to maintain the population. It is also the lowest in the OECD. During the same period, life expectancy increased from 55 years in 1960 to 77 years in 2006.
In 2006, assets in the new corporate pension system amounted to EUR 631 million in 2006, and we expect a CAGR of 70% until 2015. According to our estimates, private pension plans, the assets of which currently amount to EUR 30.4 billion, will show a CAGR of 16.8% during the same period.
Public Pensions
National Pension System
The National Pension System (NPS), established in 1988, is a partially funded, defined-benefit system. Its coverage has been gradually expanded. Initially, the scheme covered all workers in firms with 10 employees or more. In 1992, it was extended to firms with 5 or more employees. From 1995 onwards, it covered fishermen, farmers and the rural self-employed. Finally, in 1999, the urban self-employed were included in the system. These steps made a steep increase in coverage possible, from 4.4 million people in 1988 to 12.8 million people in 2006. This means that 53% of the labour force is now covered by the NPS, a high coverage rate compared to many other Asian countries. Groups that are not in the system include many self-employed as well as low-income people, temporary and daily workers as well as self-employed workers who do not declare income.
Employers and employees contribute 4.5% of wages each. The benefit formula consists of basic and earnings-related portions. The system is progressive and applies an average accrual rate of 1.5% over a 40-year contribution period. Benefits are paid mainly in the form of an annuity, which is indexed to prices, with the full pension available at age 60. The retirement age will rise to 65 by 2033. First NPS pension payments will begin in 2008, when the first participants have completed the minimum 20 years of contributions.
The debate about further NPS reforms has been ongoing. In 2003, a bill was introduced in Parliament that aimed to reduce the replacement rate from 60% to 50% and suggested that the contribution rate be increased to 15.9% by 2030. However, this bill was not accepted. In July 2007, a compromise proposal was passed in the National Assembly, which foresees that the contribution rate remains at 9%, while the replacement rate will be reduced to 50% in 2008 and then decrease by 0.5% each year until it reaches 40% in 2028.
Another reform concerns the introduction of a basic pension pillar in 2008, which will initally cover 60% of retirees with benefits equal to 5% of average wages. This benefit is meant to combat old-age poverty in South Korea. Although not decided at this stage, in the future this pillar will probably aim to provide universal benefits to all retirees with a projected replacement rate of 20%. The financing details of this new scheme have not yet been finalised. However, to achieve the extra 20% replacement rate, there must be contributions on top of the NPS.
Since payments have not yet begun, assets accumulated in the NPS have grown substantially since its inception. In 2006, assets amounted to KRW 172 trillion (EUR 142 billion). This makes the NPS one of the largest pension funds in the world. The NPS’ investment policy has gradually changed in the last few years. While a sizable portion of assets was traditionally invested in government projects such as railroad and rural infrastructure, financial market investments now account for the overwhelming majority of assets.
Despite its current surpluses, the NPS will face serious financing difficulties in the long-term due to South Korea’s demographics. Under current parameters, the fund’s surplus will be exhausted by 2047.
Other public schemes
Apart from the NPS, South Korea runs additional pension schemes for public sector employees, which were introduced before the NPS and operate independently from it. In all, they cover 1.4 million employees, or 6% of the workforce. The Government Employees Pension System was established in 1960; the Military Personnel Pension System was introduced in 1963; and the Private School Teachers Pension System came into force in 1975.
These schemes operate according to the pay-as-you-go principle and are earnings-related. At 17%, contributions are higher than in the NPS, and are equally shared between the government and employees. At around 70% after 30 years of contributions, replacement rates are generous. However, all three schemes are either already facing financial hardship, or will in the future.
Occupational Pensions
South Korea has two occupational systems that exist alongside each other. One is the severance pay system, which was introduced in 1961. In order to build a modern corporate pension system, the government drafted a severance pay reform plan in 2003, which was approved by the National Assembly in 2005. This reform aims to convert the severance pay system into a modern corporate pension system.
The severance pay system
Until recently, the severance pay system was the main pension scheme for private sector employees, and it is mandatory for companies with five or more employees. Contributions are made by employers only, who contribute 8.3% of wages. Employees are entitled to severance pay after one year of continuous employment. Companies running severance pay schemes may qualify for tax benefits of up to 30% in the case of internal reserves and 100% in the case of external funding. Investment income is tax-exempt, while benefits are taxed; benefit taxation differs for annuities and lump sums.
A shortcoming of the system is that it is mandatory for firms with five or more employees only, and such companies account for less than half of the total workforce. Additionally, around a quarter of those entitled to severance pay do not receive it because of their employers’ financial difficulties. Employers have traditionally financed severance payments through book reserves, as advance funding is not required. A 1997 reform made it easier for financial assets to be managed internally or externally though insurance companies. If employers decide to fully or partially fund severance payments, they use insurance or trust-based contracts. However, most plans continue to be based on unfunded book reserves. According to estimates, 75% of severance pay liabilities are unfunded. Benefits are typically paid out as lump sums, but annuitisation is possible.
The new corporate pension system
The new system, which is based on the Employee Retirement Security Act (ERSA), operates on a voluntary basis. Companies with five or more employees can convert severance pay into corporate pensions. This conversion needs to be based on an agreement between employers and employees, and at least 50% of a company’s employees must agree to the conversion. Unlike in the severance pay system, from 2010 onwards enterprises with less than five employees will also be allowed to participate in the new system. Part-time employees are also meant be covered by it. Employees can contribute voluntarily.
The new system allows both DB and DC plans. Plan sponsors and members are free to choose the plan they want. Much like the existing severance pay system, DB plans must provide a minimum benefit equivalent to one month’s final salary per year of service. DB funds must be managed by a separate trust, which can either be a bank, insurance or trust company. In the case of DC plans, employers must make contributions of at least 1/12 of total annual salary. Additional employee contributions are also possible.
DB plans require funding of 60% of accrued termination benefits, while DC plans must be 100% funded. Employers with less than 30 employees are allowed to offer Individual Retirement Accounts (IRA) instead of occupational schemes. These accounts are subject to the same regulatory treatment as the DC schemes. Sponsors must provide at least three investment options in DC plans and Individual Retirement Accounts, including one with an interest guarantee. Benefits are payable in the form of annuities from age 55, based on number of years of service.
Upon termination of the employment contract, employees can either receive a lump-sum payment, transfer their assets to another ERSA plan or roll it over to an IRA. The minimum benefit of one month’s salary for each year of service is always fully vested. Benefits can be paid out in the form of annuities or lump sums if the employee retires at age 55 and has at least 10 years of service. If the employee does not meet these requirements, the accumulated benefits must be transferred to an Individual Retirement Account.
A new tax law became effective on January 1, 2006. The limit allowing employees to have tax relief benefits for their personal saving plans, including ERSA plans, increased from EUR 1,984 (KRW 2.4 million) to EUR 2,480 (KRW 3.0 million). The amount of annuity income that can be deducted from taxes increased from EUR 4,961 (KRW 6 million) to EUR 7,441 (KRW 9 million) per year. Employer contributions to an ERSA DB or DC plan and investment income are tax-deductible, while pension payments are subject to taxation. Hence, taxation in the occupational pillar follows the EET principle.
Outlook
Even though it is one of the most established in Asia’s emerging economies, South Korea’s pension system is in transition. The new occupational system, the future basic pillar, as well as the National Pension System reform have changed the basic parameters of the pension system. These changes have been inevitable given the scale of South Korea’s demographic challenges. The new corporate pension plans will be essential for retirement income security as benefits from the first pillar are being trimmed down. These plans enable companies to establish formal occupational plans, a substantial improvement over the severance pay system, as it provides a much higher predictability of retirement income for employees. While the initial take-up among firms was modest, the system will experience enormous growth rates in the years to come.
All these developments and its advanced economic status make South Korea one of the key pension markets in Asia. Since South Korea will experience the demographic transition earlier than many other countries, the solutions found in South Korea have the potential to lead the way for other countries in the region and elsewhere.