Future Policy Direction

So far, the major contents of the amendment to the National Pension Act implemented in July 2007 and its expected effects have been reviewed and assessed in various aspects. Overall, the second amendment could be positively assessed, in that it sought a preemptive response to the upcoming aged society by considering various measures to stabilize the pension finance, to reinforce the vesting rights, and to rationalize the relevant institutions. At the same time, however, there are issues that should be additionally resolved and complemented from economic and welfare perspectives. In particular, the amendment has its limitations when it comes to resolving the structural imbalance of the National Pension Scheme, although it has made a remarkable contribution to the sustainability of the pension finance and equity of the scheme. Moreover, the huge benefit cuts will inevitably reduce its role as old age income security. In this section, policy directions that should be pursued in the future will be discussed based on the assessment result of the amendment to the National Pension Act.

4.1 Establishment of a Financial Stabilization Goal

As observed above, the financial instability and intergenerational inequity problems of the National Pension Scheme were caused by the internal structural imbalance between contribution and benefit, combined with the external factor of a rapidly aging population. In truth, if not for such fast demographical changes, the problem of equity among different generations or sustainability caused by differences in pension financing methods such as PAYG or a funded system could be markedly alleviated. However, with such drastic changes in population structure as are actually occurring in reality, the best alternative to enhance the sustainability of the pension finance and intergenerational equity would be maintaining a financing method based on the funded system for as long as possible (Moon 2005).

In the discussion of reform measures to stabilize the finances of the National Pension Scheme, top priority must be placed on the clear set-up of the purpose of the reform, which is directly related to the matter of social choice about which financing system should be applied to the National Pension Scheme. If the government decides to keep the partially funded pension scheme in an effort to respond to a rapidly aging population and to secure the sustainability of the National Pension Fund, the action plan for the reform will have to be prepared in a rational and concrete way to achieve such a goal. In this regard, the contents of the amendment to the National Pension Act in 2007 seem to have limitations both in terms of policy goal and policy means.

Despite considerable cuts in pension benefits under the revised act, the innate problem of the National Pension Scheme, such as the structural imbalance, was not solved fundamentally because the reform measures to improve financial stability have been coordinated without any principles or specific financial goals. Moreover, the original financial stabilization goal suggested by the NPDC in 2003 has been damaged and reduced during the process of political discussions, which is very regretful. Therefore, in future efforts to pursue reforms to stabilize the National Pension Scheme's finances, in-depth discussions over which financing method should be maintained or what should be the specific goals to achieve financial stabilization are necessary before any attempts are made to adjust pension benefit or contribution levels.

4.2 Rectification of Structural Imbalance

As presented above, the structural imbalance of the National Pension Scheme has not been fully resolved even after the amendment to the National Pension Act in 2007, which implies that the pension finance still contains problems of long-term instability and intergenerational inequity in terms of net pension benefits. Therefore, the major task for improving the sustainability and equity of the National Pension Scheme will have to be the resolution of this fundamental imbalance issue, which requires the readjustment of the current contribution and benefit level. The sooner such restructuring occurs, the quicker financial soundness can be achieved and the alleviation of the contribution burden of future generations will be addressed.

4.2.1 Contribution Adjustment

With the amendment to the National Pension Act, the income replacement rate of the pension scheme for mid-to-high income earners will fall below 30% level even for pensioners with 40 years of coverage. For this reason, there will be limitations on further benefit cuts in the future on a uniform basis. Therefore, to come up with additional measures to stabilize the pension finance, a top priority will have to be put on raising the level of contribution rate.

The improvement measures suggested by the government in 2003 focused on maintaining the partially funded system by 2070, with a decrease in the income replacement rate by 10% (from 60% to 50%) and a gradual increase in the contribution rate to 15.9%. If this financial stabilization goal is applied as it is and the income replacement rate is reduced to 40% as suggested in the latest revised bill, it is estimated that the contribution rate should be raised to 12.9% (NPDC 2003). However, the level of contribution increase does not seem to be sufficient to achieve a structural balance of the system in the long-term.

With such a contribution level, the timing of fund exhaustion might be delayed until 2070. After that, however, it will be inevitable to convert to the PAYG system, and the required contribution rate to maintain the National Pension Scheme will rise above 24% (refer to Table 3). Therefore, the only solution to prevent such a condition would be to maintain the partially-funded pension scheme, under which, the higher the funding rate, the lower the burden of future generations over contribution payment (Moon 2005). In other words, a prompt increase in the current contribution level and a decrease in excessive net pension benefits would be a feasible solution to promote the sustainability of the National Pension Scheme and to reduce excessive income transfer from next generations to current generations.

The level of increase in contribution rate and the speed of the adjustment should be determined based on the specific goals to achieve the financial stability mentioned above. If the partially-funded pension scheme should be maintained in the future, the contribution rate will also have to be adjusted in accordance with the plan and, in that case, a considerable increase in the contribution rate will be inevitable. Figure 4 presents the results of a simulation analysis over the extent of changes in the amount of pension reserve, in case the contribution rate goes up by 1.0 percentage points every three years from 2010. As illustrated in Figure 4 [ PDF 21.6KB | 1 page ], to keep the funding ratio at a stable level from a long-term perspective while maintaining the current benefit system, it is estimated that the contribution rate should go up to 15% level. If the timing and speed of contribution rate adjustment are delayed and slowed down further, the scale of increase in contribution rate will increase more, which will require a bolder decision during future reforms.

4.2.2 Benefit Adjustment

As pointed out above, without securing other complementary old age income sources in the future, it seems difficult to apply additional cuts in the pension benefit level. However, to restrict the scale of contribution increase to strike a financial balance for the National Pension Scheme, a continuous review will be necessary not only for such a uniform decrease in pension benefits but also for the measures to decrease the burden of benefit payment. In this context, other alternatives could include: (i) measures to speed up the scheduled decrease in the future; and (ii) introduction of a built-in stabilizer that allows automatic adjustment of the benefit level reflecting a demographic factor, in response to population aging.

According to the contents of the amendment to the National Pension Act in 2007, the benefit level (income replacement rate for insured people with 40-year coverage) will decrease by 10% (from 60% to 50%) in 2008, and then continue to go down by 0.5 percentage points per year from 2009 until it reaches 40% by 2028. This gradual decline in the benefit level has been designed to alleviate as much impact as possible from a sudden decrease in pension benefits and to have enough time until other measures to secure old age income such as private retirement pensions or personal pensions are activated (Ministry of Health and Welfare 2007). However, if the speed of benefit cuts is too slow, the net pension benefits for early generations of the National Pension Scheme will continue to remain, and the financial burden of future generations will become heavier. Also, even if a lump sum decrease in pension benefits is applied immediately, the actual effect of benefit cuts will appear slowly due to the grandfathering measure. Considering this, a decision to gradually decrease the pension benefits over the next 20 years seems to have reflected the relevant political interests, focusing only on the benefit to present generations. Therefore, it is critical to come up with measures to accelerate the speed of downward adjustment of the benefit level as much as possible, in the process of drawing up additional financial stabilization measures in the future.

One of the alternatives worth considering instead of decreasing pension benefits might be the introduction of an automatic balance mechanism recently adopted and implemented in some advanced countries including Sweden, Germany, and Japan⁹. All of these countries have introduced the automatic balance mechanism, which allows automatic downward adjustments of the benefit level reflecting the speed of extension in people's life expectancy, in an effort to overcome the financial crisis of their public pension systems caused by rapid population aging. This mechanism not only alleviates the pressure of further contribution increases or financial instability caused by longer life spans, but also contributes to the improvement of intergenerational equity through actuarial adjustments of pension benefits, reflecting a demographic variable in accordance with the increase in life expectancy. In particular, considering the fact that Korea is facing a serious problem of population aging that is progressing at an unprecedented speed, it seems desirable to think more actively about the introduction of an automatic balance mechanism.

4.3 Efficient Management of the Pension Fund

In operating a partially-funded pension system such as the National Pension Scheme, the efficiency of pension reserve management plays a critical role in maintaining the financial soundness of the system. Under the Defined Benefit System, the amount of benefit payment calculated through a pension formula is funded by the pension contributions collected from pensioners and investment profits of the pension fund. As a result, the lower the rate of return on the pension fund, the higher the pressure of increase in the contribution level. Therefore, the imbalanced structure of the National Pension Scheme is closely related to the pension fund's rate of return. In addition, since the funding rate of the national pension is expected to increase considerably with the amendment to the Act (see Table 3), the enhancement of the profitability of the pension fund management has become relatively more important.

The impact of the improvement in the rate of return on pension finance has been more clearly exposed in Figure 5, which demonstrates the simulation result. As observed in Figure 5, if the real rate of return on the pension fund increases by 0.5 percentage points every year compared to the presumed real interest rate, the exhaustion of the National Pension Fund is likely to be postponed by more than five years. If the gap between real rate of return and real interest is widened to 1.0 percentage points per year, the partially funded pension scheme will possibly be maintained by 2070 without additional adjustments over the pension benefit or contribution levels under the current system.

As such, not only will the enhancement of the pension fund's rate of return play a pivotal role in promoting the sustainability of the pension finance but also it will have a huge impact on determining the contribution rate for future generations. To assess the impact of changes in fund investment profitability on the contribution burden of future generations in a more quantitative way, a simulation analysis has been conducted to find out how much increase from the current contribution rate (9%) is necessary to generate the similar financial effect caused by the changes in the real rate of return on the pension fund presented in Figure 5 [ PDF 20KB | 1 page ].

As presented in Figure 6 [ PDF 20KB | 1 page ], a 0.5 percentage point increase in the rate of return on the pension fund is expected to generate the same effect as the rise in contribution rate by 0.9 percentage points, while a 1.0 percentage point increase in the rate of return is likely to have the same effect as the gain in the contribution rate by 2.3 percentage points. This implies that the efficient operation of the fund reserves will be critical for the successful maintenance of the partially-funded pension scheme, since the enhancement in the pension fund's rate of return will considerably ease the burden of contribution rates for future generations.

Table 5 [ PDF 14.6KB | 1 page ] demonstrates the result of a performance comparison between Korea's National Pension Fund and 10 other countries' public pension funds from 2000 to 2006. In this international comparison, Korea ranks above the medium level in terms of average rate of return on the national pension fund, showing a stabilized pattern. Although the national pension fund has been managed with an emphasis on its stability as revealed in Table 5, it is also positively assessed in terms of profitability. However, if only 3-year (2004–2006) average performance values are compared, the rate of return on Korea's National Pension Fund is a mere half the profitability levels of the public pensions in other countries. This is because Korea's National Pension Fund has kept a conservative attitude in pension fund management, mainly focusing its investment on bonds. The safety-based investment distribution principle can serve as an obstacle to a more flexible adjustment of strategic asset allocations in response to the changes in the investment environment such as continuous decrease in interest rates after the financial crisis and stock market recovery.

Discussions over specific measures to enhance the efficiency of the National Pension Fund management will not be addressed here since they are not in the scope of this study.¹⁰ However, in Moon et al. (2007), various issues related to the pension fund management system have been discussed. Based on this, measures to strengthen the expertise, independency, and accountability of the fund's management have been suggested. The improvement measures include the establishment of the “National Pension Fund Management Corporation” which is independent from government departments and the political circle, and imposition of independent roles to determine the investment policy on the newly established “Pension Fund Management Committee” which is composed of experts in the private sector. If fiduciary duties including the enhancement of profitability and safety of the National Pension Fund management can be reinforced through this effort to advance the fund management system, it will contribute considerably to promote the financial soundness and alleviate the contribution burden of the current National Pension Scheme.

4.4 Expansion of Opportunities to Secure Old Age Income

4.4.1 Adjustment of the Earnings Ceiling

As reviewed in the adequacy assessment, the amendment to the National Pension Act is expected to cause a decrease in the income replacement rate of the average income earners with 40-year coverage to 30% level in the long-term segment and that of highincome earners to below 20%. The reason behind this huge decline is the unreasonably low ceiling of earnings where the National Pension Scheme is applied. That is, the upper earnings limit determined at the time when the Nation Pension System was introduced has been fixed at its nominal value of 3.6 million KRW for the past 20 years, which led to the decrease in the earnings ceiling to 120% level of the average income today. As a result, a large number of workers have been restricted by this earnings ceiling, causing a huge loss in opportunities to attract additional earnings coverage.

Therefore, it seems urgent to expand the range of pensionable income, by raising the earnings ceiling to reflect income growth in the past 20 years. In the case of the US' Social Security System, the earnings ceiling is US$87,900 per year as of 2004, which is 290% of the average earnings (OECD 2007). Also, a constant ratio against which the average income level has been maintained with upward adjustments of this earnings ceiling, indexed with the average income growth rate of the whole society every year. It seems necessary for Korea to introduce such a system of linking the income growth rate with the level of earnings ceiling for the National Pension Scheme. By doing so, the social security function of the National Pension Scheme will have to be enhanced especially for the middle- and higher-income classes.

4.4.2 Activation of Other Sources of Old Age Income

Advanced multilayer old age income security systems are composed of public pensions at the national level, retirement pensions at the company level, and personal pensions and savings for old age at the individual level. Since the benefit cuts under the revised National Pension Act would lead to the contraction of the old age income security function of the National Pension Fund, it is necessary to actively vitalize the private pension market. In Korea, the “nominal” foundation for the multilayered old age income security system was laid with the introduction of the personal pension system in 1994 and the implementation of the retirement pension system in 2005. However, the function of the private pension market has not been actively vitalized until today,¹¹ resulting from various issues such as lack of incentives for pension subscription including tax benefits, insufficient means to protect subscribers, incomplete and imprudent regulations, and inadequate guarantee of portability (Ryu 2007). Therefore, it will be a very important policy task to rapidly activate the private pension market by alleviating such restrictions.

Another possible solution could be the vitalization of the recently introduced reverse mortgage market. This reverse mortgage system might be able to complement the general pension system since it can serve as a constant old age income source after retirement without concerns over securing housing finance. The activation of this reverse mortgage system will be very useful especially in Korea as an additional old age income source, considering the fact that over 80% of total assets possessed by people aged 60 and older are in real estate, and 70% of the elderly have their own houses (Park 2004). Because it is just in its initial stage, the reverse mortgage system is not yet widely recognized by people and the scope of houses to which this system can be applied is also limited. However, if actively promoted, the reverse mortgage system is likely to play an important role in the multilayer old age income security system targeting mid-to-high income classes.

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