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CHOI Ho-Sang

Korea Introduces Retirement Pension Plan

CHOI Ho-Sang

May 10, 2006

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Korea started its first retirement pension scheme in December 2005. With the fast-aging Korean society, the annual salary package system spreading rapidly, and rising number of non-regular workers, the previous system of paying retiring workers severance pay that was adopted in 1961 has proven inadequate.

The retirement pension scheme has long been in use in many industrialized countries. In the US , it contributed significantly to boosting the capital market, especially the stock market. Its adoption in Korea is also expected to bring considerable changes in the domestic stock market, thus hastening the growth of Korea's financial market.

The purpose of instituting new retirement pension system is to improve the existing system of paying out severance pay, which has been found ineffective in dealing with problems of the rapidly aging society. The total fertility rate -- the average number of children a woman can expect to have during her reproductive years -- plunged to 1.16 in 2004, down from 2.83 in 1980. The drop in birth rate leads to an aging society. According to the United Nations, the ratio of those aged 65 or over in total population is expected to surge to 34.5% in 2050 from 9.4% in 2005. The Korean government has announced that the current national pension fund will begin sustaining losses from 2036, and will reach the bottom of the coffer in 2047. The situation requires the need for efficiently managing the new retirement pension system.

The new system will be initially applied to companies with five or more employees. Between 2008 and 2010, it will be gradually implemented in companies with fewer than five workers in stages, under the authority given by the presidential decree. The new system will be enforced by taking into account an employer's ability to start the plan and the time needed by employers for its preparation.

The existing severance pay system and the current retirement pension scheme have both advantages and disadvantages. If an organization wishes to convert from one system to another, it must have an agreement of its employees. An organization with a labor union needs an agreement from a majority of workers in the union. Organizations without a union should also have an agreement from a majority of its employees. Companies that use the severance pay system can freely select from a variety of schemes taking into account the condition of the organization and preferences of its workers.

The main characteristic of the pension plan is that employees receive retirement scheme rather than a lump-sum payment upon reaching a certain age after retirement. In order to qualify for retirement pension, an employee needs to pay into the fund for more than ten years. The employee receives the pension after reaching 55 years or more. The total period that an employee will receive pension after retirement is five years.

The retirement pension plan offers a better quality of life after retirement. The existing severance pay system does have its demerits. For example, a lump-sum payment is made to workers after their retirement, but there is always a possibility for an employer failing to make such payment because he can manage the reserves rather than having financial institutions manage them. In other words, financially shaky employers may not be able to ensure reserve deposits for retirement pay-outs. Also, if the employer goes bankrupt, the employee risks losing his or her severance pay. In short, the stability of the existing severance pay system is relatively low.

The new pension plan provides two general types of pension schemes commonly known as defined benefit (DB) plan and defined contribution (DC) plan. The new pension plan also offers individual retirement accounts.

The DC plan refers to a pension plan in which the employer's burden is determined in advance and the retirement benefit can be varied in accordance with the employers' investment performance of the reserve fund.

The individual retirement account is provided to employees who switch jobs and receive severance pay or other compensation from the previous employer for use after retirement. Whether to subscribe to individual retirement account depends on the employee's preference. The employee is also eligible for tax benefits until he or she receives pension.

Under the DB plan, benefits that a vested employee receives after retirement are defined based on an agreement between the employee and management. The employee should decide the amount of reserve funds and manage it independently. The payment after retirement for a DB plan may vary according to the funding method.

Korea's retirement pay system now provides three types of pension plans: National Pension Plan, Retirement Pension Plan, and Individual Pension Plan. Such a multi-layered system to protect aging workers is the type of system recommended by the World Bank and OECD. This system is also similar to that of the US or Japan .

The retirement pension plan is likely to go through some hardships amid different opinions on the type of pensions to be introduced. This is because employees will face more risks due to price and interest rate changes when a firm introduces the DC plan, while companies will face risks when introducing the DB plan.

Meanwhile, small- and medium-sized firms are likely to suffer from financial difficulties in the early stages of its introduction as they will have to reserve retirement funds at financial institutions. On the other hand, there will be low tax benefits to employees, meaning that they will not be attracted to it. Furthermore, a company is not mandated to pursue the retirement pension plan which means that there could be conflict between labor and management. If a company chooses to adhere to the existing severance pay system, then it will take time to boost the new retirement pension system.

Nevertheless, the retirement pension system will bring many favorable changes to Korea's financial market as well as the financial industry. Retirement pension funds will flow into the stock market and thus generate ample liquidity. The retirement pension market is expected to grow to 50 trillion Won in five years and 200 trillion Won within the next ten years. Given that the total market capitalization of Korea's stock market stands at 720 trillion Won, an efficient management of retirement plan is likely to boost the domestic capital market. The retirement pension plan aims to upgrade the capital market to an advanced level, and guarantees workers a stable life after retirement. This calls for the establishment of pension fund risk management, and internal control and external screening systems by financial institutions.

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