[Talking About the Three Major Reforms] To Prevent Shifting Burdens to the Future and Populism, an "Automatic Adjustment Mechanism" Is Essential

[Hankook Ilbo · Talking About the Three Major Reforms · March 13, 2023]

Yun Suk-myung, Research Fellow at the Korea Institute for Health and Social Affairs (KIHASA) and former President of the Korean Pension Association

Pension Reform (2): Major European Countries That Moved First

As pension reform has remained at a standstill for a long time, examples of pension reform from other countries are frequently introduced to secure momentum for reform. This is the background for setting the second part of the pension reform series, which will be published in nine installments, as trends in foreign pension reforms.

The international trend in pension reform lies in the integrated operation of public pensions and the introduction of an automatic adjustment mechanism to ensure sustainability. The Organisation for Economic Co-operation and Development (OECD) Reviews of Pension Systems: Korea (2022) also recommended that all public pensions in our country be operated in an integrated manner. This is because only four OECD member countries—Korea, Germany, France, and Belgium—operate completely separate public pension systems.

Among OECD member countries, the Europe-centered members—namely, EU member states—are in conditions that are incomparably better than ours in terms of the fertility rate, which allows for projections of changes in population structure and the median age that will determine the direction of future pension reforms. While the median age in these countries is projected to increase by 5.1 years, from 43.7 in 2019 to 48.8 in 2070, ours is projected to increase by as much as 18.5 years, from 43.7 in 2020 to 62.2 in 2070. Despite this situation, most EU member states have already achieved pension reforms in a far more powerful sustainable direction than we have.

The 1998 Swedish pension reform—namely, the introduction of an automatic adjustment mechanism—which changed the operating principles of the state-run pension system to the extent that it is called the "reform of the century," had a great influence on Western pension systems. This is because 70% of OECD member countries, including Germany and Japan, introduced the Swedish-style automatic adjustment mechanism concept. An automatic adjustment mechanism is a pension operation method that excludes political judgment from pension management and automatically corrects the system so that fiscal sustainability can be ensured. Despite the fact that major OECD member countries have reformed their systems in this direction, we cannot escape the illusion of these countries' pasts—that is, their pension systems before reform. We only emphasize the level of pension benefits received without bearing even half of the contributions.

Major European countries operate their pension systems by resolving the operating costs of the pension system for the current year—that is, the system's operating cost—within that same year. By bearing contributions every year in an amount equal to the pension benefits they will receive in the future, they operate in a manner where no unfunded pension liability (Unfunded accrued liability) occurs in each fiscal year. Unfunded pension liability refers to the amount by which the fund is insufficient for pension payments—that is, the amount remaining after subtracting the accumulated fund from the pension benefits already promised to be paid.

Following recent pension reforms, European countries regard pension contributions not as taxes but as amounts that can be received back in the future. In other words, they view the contributions paid by the insured as a concept of savings (Armand Fouejieu, et al., Pension Reforms in Europe - How Far Have We Come and Gone?. International Monetary Fund, pp.23-24). Germany's pension point system reform and Austria's 2005 reform are operated with a strong reflection of an actuarial nature—that is, the concept of receiving back what one has paid—compared to past pension systems.

This is an approach fundamentally different in nature from our pension discussions, which put forward the outdated public pension operating principle of intergenerational support and unconditionally demand that the state take responsibility without any countermeasures even in a situation where the fertility rate has plummeted. Because they operate their pension systems in a way that does not shift a heavy burden to future generations, the benefit rates do not differ significantly from those of the National Pension, despite the fact that they bear contributions at a much higher level than the National Pension.

Despite having a much better population structure than ours and bearing twice as many pension contributions, Sweden, Norway, and Finland—excluding Denmark—have abolished the universal tax-financed Basic Pension. Even in Denmark, which maintains a universal Basic Pension, retirement pensions operated by companies account for a large portion of old-age income security. These are vivid international examples showing that the argument for introducing a universal Basic Pension financed by taxes lacks feasibility.

During the severe economic recession of the early 1990s, Finland drastically reduced the universally operated Basic Pension and overhauled its old-age income security system to center on an earnings-related pension. Instead, for low-income groups, the state provides a tax-financed guarantee pension to secure the national minimum (poverty line) set by the state. It ensures adequate old-age income by adding a benefit with in-kind attributes called a housing allowance.

The earnings-related pension in Finland, which requires a contribution of approximately 24%, does not provide large benefit amounts even when including the means-tested Basic Pension. The average total pension amount (as of the end of 2021) is 1,784 euros (which has increased to approximately 2.5 million won due to the recent surge in exchange rates). Finland, which operates its public pension and Government Employees Pension identically, does not provide the retirement allowance paid to our civil servants (up to 39% compared to private severance pay), yet it pays a much smaller Government Employees Pension than we do (while the annual benefit rate of our Government Employees Pension is scheduled to drop to 1.7 only in 2035, the current annual benefit rate for the Finnish Government Employees Pension is 1.5), and its Government Employees Pension contributions have already exceeded 28% (compared to 18% in Korea).

For more than the past 50 years, Germany has borne contributions up to six times higher than ours, and currently still more than twice as high (18.6%). Despite this, the public pension income replacement rate in 2030 is projected to be 38%, and the average annual accrual rate is projected to be 0.82 (the Korean National Pension is at a level of 1.06; a larger number indicates a higher pension amount). While these projections may vary according to the 'conditions of the 2018 German Grand Coalition agreement to suspend the operation of the automatic adjustment mechanism for several years,' there will likely be no significant difference in that the mechanism is expected to eventually resume due to fiscal instability. These projections are based on a discussion I had with Professor Axel Börsch-Supan of Germany at an international seminar in 2022.

The income replacement rate of the public pension in Sweden, which has a better population structure than ours and bears contributions of 18.5%—more than twice our rate—is in the low 30% range. The total income replacement rate, including other pensions, is also projected to fall below 40% after 2050. Regarding the effective pension contribution period, a major point of contention in our pension discussions, Sweden achieved 41.3 years in 2019 and is expected to remain around 40 years even after 2060. They pay only this much even though the average public pension contribution period already exceeds 40 years and they bear more than twice the contributions we do. This is how they are able to ensure the sustainability of their pension system.

Conversely, we estimate the average contribution period for the National Pension to be 27 years even 50 years from now. It is necessary to examine whether the assumption of an average contribution period of 27 years—which means living for 70 years supported by someone else in the era of a 100-year life—is truly realistic. I say this because the argument that the income replacement rate of the National Pension must be raised further, on the grounds that the actual pension income replacement rate is low due to the short average contribution period, continues to cause confusion in our society.

Source: Hankook Ilbo (original article)