Design a Three-Tiered System of National, Retirement, and Personal Pensions

[JoongAng Ilbo · November 11, 2007]

Yun Suk-myung, Ph.D. in Economics, Head of the Pension Insurance Team at the Korea Institute for Health and Social Affairs (KIHASA)

There was a time when children were a reliable means of preparing for old age. This was because the custom of relying on children for old-age security instead of passing down assets had been maintained for a long time. Our parents' generation, who lived within this tradition, believed that raising children well was the safest measure for old-age security.

However, as the extended family society collapsed and nuclear families became the norm, most countries hurried to introduce public pensions (pension schemes operated by the state). Older people in developed countries, which introduced public pension schemes over 100 years ago, are spending their old age comfortably by relying on pensions instead of children.

Warning lights have begun to flash for these pension schemes. This is because while the number of older people is increasing rapidly, the economically active population to support them is not growing as expected, making it difficult to maintain pension schemes where one "pays little and receives much." Even when governments, feeling a sense of crisis, attempt to overhaul the systems toward "receiving less and contributing more," they are unable to implement proper reforms due to opposition from citizens who fear benefit cuts.

The National Pension Alone Cannot Cope. Korea is no different. Because of the fiscal instability of the Government Employees Pension, introduced in 1960, 1.25 trillion won in taxes must be injected next year. Efforts to fix these problems are facing difficulties due to opposition from civil servants. The National Pension also improved its system for fiscal stabilization this July after many twists and turns, but the fundamental problems remain unresolved.

These problems will worsen over time. In Korea, where aging is progressing at the fastest rate in the world, it is projected that if system improvements are not made in time, it will escalate into a national disaster. In 1970, 17 workers supported one older person, but by 2050, 1.4 people must support one older person. If not fixed in time, the burden on future generations will inevitably increase.

Despite this situation, most countries in the world, including Korea, do not have proper old-age security measures. Even where they exist, they rely mostly on public pension schemes. This level of preparation cannot handle the coming super-aged society (where the proportion of the older population is 20%).

The state, corporations, and individuals must share responsibility for old age. Recognizing these problems, the World Bank published a report in 1994 titled "Averting the Old Age Crisis," presenting a basic direction for old-age planning. In this report, the World Bank made it clear that in a super-aged society, public pension schemes like the current ones, where the state takes full responsibility for an individual's old age, will be difficult to maintain.

Instead of the state taking full responsibility for the old age of citizens through public pensions, it proposed a recommendation to evenly share the responsibility among corporations that employ workers and individual citizens. It sought to minimize the role of the state in old-age income security and have the private sector take over the remaining responsibility. In other words, it suggested solving the problem of livelihood in old age through the balanced development of public pension schemes operated by the state and private pensions managed by the private sector. This was an application of the risk minimization strategy through diversification, commonly used in stock investing, to the old-age income security system.

The strategy proposed by the World Bank is a multi-tiered income security system. The first tier is the public pension scheme operated by the state, the second tier is the corporate pension scheme managed and funded by corporations, and the third tier is designed for individuals to directly save a portion of their old-age funds through private financial institutions. To this end, it recommended that while public pension resources be provided through taxes or contributions from the insured, the system should be designed to ensure benefit amounts above the minimum cost of living.

However, in cases where public pension resources are funded by taxes, high-income earners were to be excluded from pension benefits. This was because it was judged undesirable to collect so many taxes that the working class's backs would break just to pay pensions to high-income groups who do not need state assistance.

Furthermore, it called for severance pay borne by the employer (in Korea's case, 8.3% of monthly wages is paid as severance pay) to be converted into a pension—namely, a corporate pension—rather than a lump sum, to eliminate the practice of spending severance pay whenever one changes jobs. This took into account the fact that most workers do not fully realize they need stable income after retirement.

In addition, it suggested that individuals prepare additional old-age income under personal responsibility by setting aside a portion of their earned income to join personal pensions or pension insurance at private financial institutions. Since the World Bank's old-age design plan was presented, most countries have been restructuring their old-age income security systems so that public pensions and private pensions can develop in balance. The World Bank's old-age design plan is being recognized for its validity in countries around the world.

Retirement Pensions Must Be Mandatory. Korea also has a three-tiered system consisting of the National Pension, retirement (pension), and personal pensions, so on the surface, it appears to be a country that has actively adopted the World Bank's recommendations. However, the reality is different. First, for the National Pension to serve as a reliable support for old age as a minimum safety net, additional fiscal stabilization efforts must follow.

The retirement pension system introduced in 2005 is not being activated because it allows a choice between severance pay and a retirement pension. Retirement pensions should be made mandatory, but incentives are needed, such as expanding the scale of deductible expenses for employers and the scope of tax benefits for workers.

Personal pensions have degenerated into a tax-saving tool for high-income workers. Additional tax benefits must be established to encourage low-income groups and the self-employed to actively participate in personal pensions.

Source: JoongAng Ilbo (original article)