The National Assembly Special Committee on Pension Reform Should Study the OECD's Method for Calculating the Income Replacement Rate

[Asia Today · Yun Suk-myung Column · August 11, 2024]

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

One must contribute for 40 years to receive a pension equal to the current National Pension income replacement rate of 42%.

However, in reality, the average contribution period is 26 years, meaning the effective income replacement rate is only 27.3%.

There is a large gap between theoretical and actual pension benefits due to the dual structure of the labor market and the seniority-based wage system.

The core of France's pension reform was requiring people to work two more years to receive full benefits, which previously required 42 years of work.

The desperate debate over the income replacement rate is meaningless, as it shifts problems that should be solved through the labor market onto the pension system.

The low mandatory contribution age is also a factor that significantly lowers the income replacement rate.

The theoretical income replacement rate, defined as the ratio of pension benefits to income over the working period, is at the center of the pension debate. This is because one must contribute for 40 years to receive the current National Pension income replacement rate of 42%. Since late entry into the labor market and early retirement are common practices, attention is focused on the effective income replacement rate based on the expected contribution period. This is why, even in the era of a 100-year lifespan, the average contribution period for the National Pension 50 years from now is estimated to be around 26 years.

The argument to further increase the income replacement rate stems from the fact that a 26-year contribution period lowers the effective income replacement rate to 27.3%. In most OECD member countries, the gap between the theoretical and effective income replacement rates is not large. The reason this is uniquely problematic for us is the rigid labor market—specifically, the dual structure of the labor market and the seniority-based wage system. This is the background why the need to transition to a productivity-based wage system and job-based pay has been further emphasized recently.

This is something I, who was responsible for fiscal stabilization measures at the Fifth National Pension Financial Estimation Committee and the Advisory Committee to the National Assembly Special Committee on Pension Reform, have often said: "Projecting a contribution period of 26 years even 50 years from now means that the official economic activity period recognized by the state is 26 years. If one lives for 100 years but is economically active for only 26, it means they must depend on someone else for the remaining 74 years. Can such a society be sustainable? If one lives for 100 years, should they not work for at least 40? Even then, they are supported for 60 years!"

The reality of France's pension reform lies in the contribution period. Previously, one could receive full benefits by working for 42 years. The core content of the French pension reform is to require working two more years to satisfy a 44-year period. This means that France is already filling 42 years. Our pension system was transplanted from Germany via Japan. The average contribution period for German male workers reaches 35 to 40 years. Their calculation period for the income replacement rate is 45 years, which is five years longer than ours. Since they must contribute for five more years, it means that if the income replacement rates are the same, ours is higher than Germany's. Japan's basic pension (called the National Pension), which requires contributions to receive benefits, is considering a plan to extend the contribution period by five years, from 40 to 45 years. Despite the situation in these major countries, we are the country arguing to further increase the income replacement rate based on the premise that the contribution period will be only 26 years 50 years from now.

The desperate debate over the income replacement rate is far removed from the essence of the problem! This is because problems that should be solved through the labor market are being shifted onto the pension system. This is why I criticize the discussions for being conducted in a state of isolation, like the Galapagos Islands, far removed from international trends. We must accurately understand the reasons why the income replacement rate is calculated low by distinguishing between internal pension issues and external factors. Most OECD member countries operate a 100% earnings-related pension system. Because the National Pension has a very strong income redistribution function, the income replacement rate for the middle-to-high income group is significantly lowered, even if it were identical to other countries. That is not all. A large gap between the income recognized by the National Pension and the actual income of contributors is further lowering our income replacement rate.

The OECD calculates the income replacement rate based on the average wage of regular employees. As of 2023, the A value (the economy-wide average of insured earnings), which is the average income of National Pension contributors (2.86 million won per month), is much lower than the average wage of regular employees (4.21 million won per month). This is due to the large number of self-employed individuals with low incomes. The difference between high-income workers' wages and the maximum income recognized by the National Pension (5.9 million won per month) is also a problem. Due to the strong income redistribution function and the gap with actual wages, the income replacement rate for high-income earners is significantly lowered. This is why, by OECD standards, the income replacement rate for average earners is 31.2% (excluding the Basic Pension), while the income replacement rate for high-income earners—those with twice the average income—is 18.8%.

The internationally low mandatory contribution age is also a factor that significantly lowers the income replacement rate. [If the contribution age were extended by five years to 64, the income replacement rate would increase by 13%, and the income replacement rate for an average earner who satisfies the full contribution period would increase from 35.4% to 39.9%. (OECD Reviews of Pension Systems: KOREA, 2022, p. 96)].

Retirement pensions, whose total contribution revenue is nearly equal to that of the National Pension, were applied to only 53.3% of eligible persons as of 2021. This is from a Q&A session between me and Andrew Reilly, an OECD pension analyst, at last year's OECD pension experts meeting: "How can our retirement pensions be included in the OECD income replacement rate calculation standards, like those of Denmark, the Netherlands, and Australia? .... If retirement pensions are applied to more than 80% of eligible persons, they can be included in Korea's income replacement rate."

If retirement pensions are recognized as a pillar of old-age income, and if the Basic Pension is also properly included, the income replacement rate by OECD standards will rise significantly. Improving the system's operation and reforming the labor market so that the reasons for not being recognized as part of the income replacement rate can be resolved should be the core of the income replacement rate debate. Nevertheless, this was not even mentioned in the 21st Special Committee on Pension Reform. They only argued to raise the National Pension's income replacement rate. That is why it is considered substandard.

In the 22nd National Assembly, the debate over the income replacement rate must be conducted after proper study. This is because they are mentioning only pathetic measures while debating without a good understanding of why the income replacement rate is low. If discussed separately from labor market reform, it becomes even more difficult to find a solution for the appropriate National Pension income replacement rate. By studying the OECD's calculation standards well, a way to solve the low income replacement rate can be easily found. Above all, the urgency of overhauling the National Pension into an earnings-related pension must be understood as soon as possible. This is because it is the most central structural reform of the pension system!

Source: Asia Today (original article)