Pension reform is a top priority for Korea

Pension reform is a top priority for Korea

The 2022 OECD Economic Survey of Korea, published in September, highlighted the need to strengthen the social safety net. In particular, the share of the population aged 65 and over living in relative poverty exceeds 40%, nearly three times the OECD average (Figure 1). Ensuring adequate retirement income requires reforms to improve the National Pension Service (NPS), expand the company pension system, encourage private savings and reform the basic pension.

Pillar 1: The National Pensions Service

The Investigation noted that the average pension paid by the National Pension Service (NPS) was only one third of the minimum wage in 2021. The low pension amount reflects the short average contribution period of 18.6 years for new pensioners, even though the NPS was established in 2021. 1988. Also, there are gaps in coverage. In 2021, only around 60% of the population aged 18-59 contributed to the NPS in 2020 despite the legal requirement for all workers to participate. Confidence in the NRP has waned as the target replacement rate (the retirement benefit as a percentage of pre-retirement earnings) fell from 70% to 40% in 30 years. According to the OECD measure, the gross replacement rate of a full-career worker with an average salary is 31%, well below the OECD average (Chart 2). Raising the target replacement rate is key to reducing the old-age poverty rate in the long term.

Moreover, the Investigation calls for extending the period of contribution to retirement by prolonging working life, in part by limiting the practice of “honourary retirement”. Companies are forcing a significant share of workers to retire before the mandatory retirement age (which must be at least 60), reflecting the seniority-based pay system which tends to raise wages above the productivity of older workers. In addition, the age of eligibility for a pension is 62, thus exceeding the mandatory retirement age. About two-thirds of people aged 55 to 64 in 2021 had left their career jobs before reaching retirement age. Their average retirement age was 49.3 years and their professional seniority was only 12.8 years. In 2006, the government introduced subsidies for the “peak wage system”, which freezes or gradually reduces the wages of older workers to encourage companies to retain older workers. In 2020, only half of companies with more than 300 employees had implemented the salary peak system, reflecting the opposition of workers. The Investigation states that Korea needs “a flexible salary system based on performance, job content and skill requirements”.

Pension spending is expected to triple by 2050 and the National Pension Fund would be phased out by 2057 under the current framework. The Investigation emphasizes that raising the age of eligibility for retirement would support the financial sustainability of the NRP while helping to reduce old-age poverty and the impact of rapid population aging on the labor force. The retirement age is 62, one of the lowest in the OECD (Chart 3). It is expected to gradually increase to 65 by 2034 but would remain low by international standards. With the increase in life expectancy, the expected duration of retirement has increased from 14.1 years for Korean men in 2014 to 18.4 years in 2020, and from 19.6 years to 23.2 years for Korean women. The Investigation recommends that Korea “raise the age of eligibility for retirement by 2035 from what is currently provided by law and then link it to life expectancy.”

Another priority is to raise the pension contribution rate, which is 9%, half the OECD average and one of the lowest in the OECD. Under the current framework, the contribution rate would need to more than double to fund the government’s current target replacement rate of 40% (as calculated by Korea) over the long term. Raising the target replacement rate from its current low level would require an even larger increase in the contribution rate.

Pillar 2: The company pension plan

The second pillar of the Korean pension system is the private company pension, which allows employers to convert mandatory lump-sum severance payments into defined benefits, defined contributions, or an individual retirement pension. Severance pay, also known as retirement allowance, requires employers to pay one month’s salary for each year of employment to departing employees. In 2021, 96% of those eligible for retirement chose the lump sum severance payment.

Workers tend to prefer a lump sum severance package partly because of the prevalence of honorary retirement, which forces them to leave companies at a relatively young age. The lump sum can be used to start a business to earn retirement income. Lump-sum indemnities encourage companies to carry out honorary retirements because the lump-sum is a multiple of the end-of-employment salary, which increases rapidly with seniority. Companies tend to avoid setting up a company pension scheme because it requires companies to place 100% of the funds with financial institutions, unlike the lump sum payment, which does not have to be funded out of outside the company. This jeopardizes workers’ flat-rate benefits in the event of company bankruptcy. The Investigation emphasizes the importance of transferring lump sum severance pay to individual retirement accounts.

Pillar 3: Individual pension

Individual retirement savings in Korea represent only 32% of GDP, compared to 100% for the whole of the OECD zone (Chart 4). The low level reflects the relatively recent introduction of the system, low participation rates and low savings returns. In addition, the tax advantage of individual retirement savings compared to a reference savings vehicle is relatively low. The Investigation suggests increasing tax benefits and introducing automatic membership for all workers with the possibility of opting out to stimulate participation in individual pension schemes.

Reform the basic pension

In the short term, the key to reducing old-age poverty is the basic pension, which was introduced in 2008. It is a tax-financed benefit that provides an income for people aged 65 year. Coverage is very broad – around 70% of the elderly – but the benefit is low at 8% of the gross average wage (Chart 5), which limits its impact on the poverty rate for the elderly. Doubling the amount of the benefit would only reduce the old-age poverty rate to 33%, which is still well above the OECD average (Figure 1). The Inquiry concludes that the benefit should be increased while better targeting it to those who need it most.

Conclusion

President Yoon’s government plans to reform the pension system. Reform should take steps to sharply reduce old-age poverty while creating a financially sustainable public pension to provide income for the elderly. It is essential to stimulate private pension savings – namely company pension schemes and individual pension schemes – as additional pillars of income for the elderly.

Randall S. Jones is a non-resident scholar at the Korea Economic Institute of America. The opinions expressed here are those of the author alone.

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