The management method of the National Pension Fund must be

changed

existing reserve fund, income distribution fund, and income proportional fund

 Wonshik Kim

Chairman of Harmonious Society Research Center,

                                                                                                                                                                                                   Korean Peninsula advanced Foundation

Emeritus Professor, Konkuk University

Visiting Professor, Georgia State University

Parametric reform is not a reform, but an ‘adjustment’

In late May, the Korea Development Institute (KDI), which designed Korea's national pension program, announced at a seminar with the Korean Economic Association that the financial management of the national pension should be changed to a funding method for financial stability and sustainability. After considering 24 options from the 5th Financial Recalculation Committee and 4 options from the National Pension Reform Committee of the 21st National Assembly, the pension reform process has narrowed down to two potential choices. Two final plans are as follows: option one is to increase both the replacement rate from 40% to 45% and contribution rate from 9% to 15%; and option two is to maintain 40% replacement rate while increasing the contribution rate from 9% to 13% to strengthen financial stability.

The National Assembly proposed a compromise option setting the contribution rate at 13% for both the ruling (right wing) and opposition (left wing) parties, while differing the pension premium at 14% for the ruling party and 15% for the opposition. The problem is that no matter which plan is passed by the National Assembly, these parametric reforms are in fact 'adjustments' rather than reforms or revolutions. These parametric reforms alone cannot stabilize national pension finances and will likely lead to ongoing intergenerational conflict and extreme populist policies during every election.

It is highly positive that KDI, a government-affiliated research institute, has presented a reform plan for the national pension’s funding method from a different perspective than that of National Assembly’s pension plan. The Korean Peninsula Advancement Foundation (Hansun Foundation) has long ago proposed the necessity and method of accumulating national pension fund through several reports and seminars, including policy agendas for general or presidential elections.[1] Of course, the content is different from those of KDI. However, we positively evaluate the fact that the discussion on the national pension funding method began at a research institute under the government's Ministry of Strategy and Finance, and we believe that the future reform discussions of the 22nd National Assembly or the government should create an inevitable restructuring plan in this direction and implement it as soon as possible.

Urgent change in national pension financial management method

The financial management method of the National Pension is either a funding method, in which a fund formed from pension premium is accumulated and operated, and the benefit is determined according to the sum of principles, or a non-funding method, in which the pension premium is determined according to a set benefit without accumulating funds, that is, a pay-as-you-go method.[2] Unlike the advanced countries, South Korea's National Pension System uses a partial funding approach. This means contributions from workers and employers are not entirely used to pay current benefits. Instead, the remaining portion is invested in a reserve fund to help guarantee future retirees receive benefits while they are alive. However, with a growing number of retirees and a shrinking pool of contributors, the national pension fund is expected to face difficulties accumulating surpluses. This could lead to a situation where future benefits cannot be guaranteed by the National Pension Agency (NPS). In the 2050s, the fund is expected to be depleted and it may inevitably be required to switch to a non-funded method, that is a pay-as-you-go method.[3]

In general, when looking at the method of determining pension  premiums, the funding method is called a defined contribution plan, and the non-funding method is called a defined benefit plan. The Korean national pension is a defined benefit plan in which benefits are determined based on a formula based on the amount and period of insurance premiums paid.

Pension Benefit = 1.2 (A + B) x (n-20)

Where A is the average annual income of all contributors

           B is the contributor’s lifetime income

           N is the number of contributed years  

The strengthening of coverage (that is, the increase in replacement rate) advocated by the opposition party calls for reform of the exiting benefit formular. Therefore, the pension premium rate must be adjusted accordingly to ensure financial stability. Because the pension premium is not being adjusted in line with the already determined pension benefits, a substantial unfunded liability is bound to accumulate unless there is a significant increase in the premium rate in the future.

In principle, the choice between a funded or unfunded method for national pension program should be based on a comparison of the sum of the economic growth rate and population growth rate to the interest rate. In simpler terms, if the interest rate is higher, a funding program should be used, and if the sum of economic growth rate and population growth rate is higher, the unfunded plan or pay-as-you-go plan should be used. Now, Korea faces a pressing need to transition to a funded pension system. This urgency stems from the country's declining population, reflected in its negative growth rate, and the slowdown in its potential economic growth.

Moreover, the combination of a shrinking workforce due to low birth rates and a rapidly aging baby boomer generation threatens the sustainability of the current partial funding system. It makes a fully funded approach increasingly necessary to avert chaos that will greatly shake the social foundation itself. There is no choice. In a democratic society, it is not possible to require a young person to take responsibility for an old person and pay 29.8 % of his or her income (the 2060 pay-as-you-go based pension premium rate) as a pension to the elderly over 65 years of age.[4] The sustainability of the national pension is not achievable unless the current financial management method is converted to a funding plan where contributions are invested for future payouts.

KDI National Pension Restructuring (Proposal)

KDI's plan is to convert existing pension liabilities into national debt, inject government finances, and introduce a new fully funded pension system. Existing pension debt is estimated at 600 trillion won (461.5 million Dollars, 1 Dollar=1300 Won)  and government bonds are issued as much. And a fully funded pension is created with a cost-benefit ratio of one.[5] They summarize the reform process as follows:

1)    Suspension of the old pension system at a certain point

2)    The unaccumulated provisions of the old pension (currently around KRW 600 trillion) are guaranteed by the government.

3)    Introduction of a new pension system with an expected cost-benefit ratio of one

4)    The new pension system is designed as a defined contribution type (DC type) to ensure financial stability.

5)    To secure the income redistribution function of the new pension, the introduction of CCD type C that allows income transfer within the same age (cohort)

The core of KDI proposal calls for the issuance of government bonds for 600 trillion won in unfunded national pension liabilities. However, this plan amounts to 50% of the current national debt of 1,200 trillion won (923.1 million Dollars) in 2023, and the annual interest for the additional issuance of 600 trillion won is a burden of 24 trillion won (18 million Dollar) even when calculated at an annual interest rate of 4%.

Hansun Foundation National Pension Restructuring (Proposal)

On the other hand, Hansun Foundation's National Pension proposal divides the national pension benefit into income redistribution benefit and income-proportional benefit, so the government is responsible for the income redistribution benefit as a defined benefit type, and the income-proportional benefit as a defined contribution type. The idea is to operate it on a funding basis where benefit is determined based on its rate of return. In other words, the government receives half of the pension premium and pay the benefit by supplementing it with government budget based on income redistribution. The remaining half is saved as a fund and the benefit is adjusted and paid according to the rate of return. Therefore, high returns guarantee high benefits.

1)    The fund accumulated through future insurance premiums shall be managed separately from the existing fund.

2)    The future reserve fund will be managed separately into an income redistribution fund and an income proportional fund.

3)    The income redistribution fund is a defined benefit type and is used to pay one- half of the current pension. Fund shortages will be compensated with funds raised by abolishing the basic pension.

4)    The income-proportional fund is annualized and paid based on the rate of return according to the individual's contribution amount.

5)    The existing reserve fund, income redistribution fund, and income proportional fund are operated independently and compete based on their rates of return.

6)    Poverty of the elderly, which cannot be resolved despite the receipt of national pension benefits, is supported by the basic livelihood security system and the revitalization of elderly labor.

 The basic concept of the Hansun Foundation (plan) is to operate income redistribution benefits and income-proportional benefits separately, and to integrate income redistribution benefits and basic pension. This can increase the probability of sustainability of the national pension system by diversifying the risk of national pension payments. In addition, to improve financial stability, if the pension starting age is raised from the current 65 to 70, pension payments can be reduced by more than 30%. At the same time, if we revitalize the labor market of the elderly by providing a fourth layer of coverage on top of the three layers of national pension, retirement pension, and personal pension, we will be able to form a stable foundation for an aging society.

Not only Korea but also other countries are operating very diverse and creative pension systems to prepare for aging. At the beginning of its introduction, Korea is applying a benefit formula that is the sum of income distribution benefit and income proportional benefit. Therefore, compared to other countries, it has a benefit formula that is easier for citizens to understand. If politics can be excluded from national pension reform, I believe that with the government's rational leadership, experts from various fields can create a sustainable alternative that can help the public understand and receive support.