OPINION
2021 Mar/23
DC Plans and Default Investment Options
Mar. 23, 2021
PDF
- Summary
- Retirement pensions have a public aspect as they are mandated by the government for the purpose of post-retirement income security amid population ageing. Of the two types of retirement pension plans─defined benefit (DB) and defined contribution (DC), a shift towards DC plans has been a global trend due to DB plans’ increasing financial burden on employers. Korea is expected to see DC plans increasing fast as more and more small- to medium-sized firms are mandated to introduce the retirement pension scheme. However, DC plans require the members to manage their assets for a long investment horizon on their own, which is often pointed to as a structural flaw in terms of the scheme’s initial intention of post-retirement income security. One of the most effective institutional fixes to this problem is a default option. Already, several bills were proposed to introduce the default option in Korea, but the introduction was delayed several times due to concerns about a principal loss. In managing long-term assets such as retirement pension assets, a short-term valuation loss is not an intolerable risk factor. Designing a default option totally without any valuation loss in annual term is contrary to the initial policy intention. The current situation where over 80% of retirement pension assets are repeatedly rolled over into one-year time deposits can be hardly interpreted as reflecting plan members’ rational risk-adverse behavior. More likely, it could have stemmed from the members’ lack of interest and capability for managing their investment. What’s needed now is an institutional tool that first defines tolerable levels of risks across different age groups taking into account the retirement timing, based on which to build a well-diversified investment portfolio. Now, more than ever before, is the time to benchmark best practices in other advanced markets for formulating and introducing an effective default option scheme.
Introduction
It has been 16 years since the retirement pension scheme has been adopted in Korea. The policy objective behind the scheme was to bolster employees’ pension right that had been insufficiently protected by the previous severance pay scheme. The pension right here physically refers to protecting employee benefits against plan sponsors’ bankruptcy by mandating the sponsors to deposit their share of contribution outside the firm. In a broader sense, the pension right means the retirement pension scheme playing a greater role in securing post-retirement income for employees. That line of policy objectives—viewing retirement pension as a policy tool for bolstering post-retirement income—should be the criterion in assessing the appropriateness of many pension reform plans currently being discussed primarily by the Ministry of Employment and Labor.
Most economies with a developed pension scheme including Korea have institutionalized the retirement pension scheme by mandating individuals to save for post-retirement life, rather than leaving it to the discretion of individual employees. This is based on the widely-held perception that individual rationality is limited so that it could be hard for each individual to fully prepare for post-retirement life in advance. In line of that perception, DB plans whose retirement benefit is defined in advance appear to fit better to the intended purpose of the retirement pension scheme. However, many firms tend to shift away from DB plans towards DC plans for prudential and other reasons. A great number of social welfare experts have expressed concerns about the tendency that could dilute the scheme’s intended purpose of securing post-retirement income. From the behavioral economics perspective, DC plans have a structural flaw. According to international organizations such as the Working Party on Private Pensions (WPPP) or the International Organization of Pension Supervisors, such a flaw could be addressed by institutional fixes such as hybrid plans and default options to be discussed in this article.
Against the backdrop, this article tries to explore the meaning and necessity of default options in DC plans, with a review on the revision bill on the Act on the Guarantee of Employees’ Retirement Benefits (the Act, hereinafter) currently pending in the National Assembly. With the super-low interest rate lingering further, long-term investment in principal-protected products is completely unfit for the retirement pension scheme’s intended purpose. This article tries to present a reasonable way to set up default options from the long-term investment perspective by assessing the actual meaning of the risk of principal loss, one of the concerns often mentioned by opponents of default options.
DC plans
Bracing for rapid population aging, OECD has long underscored the importance of building a multi-pillar pension system that consists of a combination of the public pension scheme often mandated by law, and the private pension scheme voluntarily chosen by individuals. In Korea, the public pension scheme including the basic and national pension systems constitute a zero pillar and the first pillar, whereas the second pillar refers to the retirement pension scheme and the third pillar to the private pension scheme such as individual pensions.1) However, Korea’s retirement pension, except for individual retirement pensions (IRP), is compulsory to almost all wage workers, which makes it similar to part of the public pension. Although diverse perspectives on social welfare such as public pension should be accepted, the public aspect should be a priority in discussing the appropriateness of government policies.
The essence of the retirement pension scheme lies in a mandated system where a nation obligates private sector firms to take some responsibility for their employees’ post-retirement life that is in the private sphere. In that sense, DB plans would serve better for the nature. By contrast, DC plans appear to have a logical flaw: Despite the mandated subscription on the reason of the short-sighted and irrational nature of individuals, DC plans emphasize those individuals’ capability and responsibility in managing plan assets. The pension system has evolved differently across nations, but what’s common in most nations is the lack of investment capability among individual plan members for managing their long-term investment such as retirement pension plans. Nations with a developed pension system have consistently shown that policy effort such as publicity or education programs cannot address or ease the issue of individual investment capability in DC plans.2)
This is why most nations with a developed pension system view default options as an essential element to DC plans. Default options are the most effective institutional means that helps address behavioral economics biases inherent in DC plans. In other words, providing DC plan members well-designed default options is the basic responsibility of a nation that mandates retirement pension. Korea’s current condition of retirement pension empirically shows that without proper default options, most of the DC plan assets would sit idle and remain uninvested.
Under the super-low interest rate environment, quite a few DC plan members keep rolling over 1-year time deposits. Some view this as a result of those members’ voluntary, risk-averse behaviors, which is inappropriate. With the interest of time deposits falling far short of inflation, the high proportion of time deposits should be interpreted as investors’ ignorance or inaction, instead of their investment decision. Of course some of the time deposit investors must have willingly placed their assets in those products because of their extreme risk aversion tendency. What’s important in building a concrete execution system for default options is to prevent this type of investors from investing in risky assets against their risk appetite. This would be possible by properly informing investors about how their assets are invested and managed under default options, and by requiring them to regularly review their investment instruction.
Issues worth considering in designing default options
Recently, the Environment and Labor Committee in the National Assembly has been reviewing the revision bill on the Act on the Guarantee of Employees’ Retirement Benefits, proposed for introducing default options.3) Similar bills were already proposed and submitted by the government and other lawmakers to the committee during the 19th session several times. However, the session ended without sufficient committee discussion, and those bills were automatically scrapped. The currently discussed revision bill focuses on the plan to introduce default options in DC plans under the name of “prior investment management designation”.4) However, the bill is currently pending in the committee amid concerns about the possibility of legal disputes over the risk of principal loss from default options that usually come without principal protection.
The key policy issue to be addressed towards default options is who sets up the options, which will be closely related to who is held liable for potential legal issues in the future. This is also part of reasons hindering the introduction of default options in contract-based governance. Under the currently discussed revision bill, default options are set up by financial institutions (plan providers), instead of employers (plan sponsors). Simply put, an investment manager—a retirement pension plan provider—designs default options based on predefined criteria and presents them to plan members after acquiring approval by the Employment and Labor Minister. In the US, it is the employer who sets up default options. It is well-known that the pension reform providing employers immunity from litigation related to any loss from investment-linked default options gave a boost to the adoption of default options. Korea should give plan providers such immunity, with some product design criteria—similar to the Qualified Default Investment Alternatives (QDIA) in the US—being part of the Employment and Labor Minister’s approval.
In trust-based governance in Australia, retirement pension funds are the one who sets up default options. Australia’s superannuation allows individual employees to opt for a specific fund. Competition between funds is known as a key driver for pension development. The point of the competition lies in default options set up by individual funds. Given that over 80% of employees opt for default options in managing their plan assets, a retirement pension fund’s solid and stable return on its default options can serve as a competitive edge. Australia has adopted MySuper that replaces existing default options since 2011 in the nation’s move for facilitating competition among funds. By limiting fee levels, MySuper improves the quality of default options. Under the system, one fund is allowed to set up only one default option while being mandated to disclose its asset composition, performance, and other standardized details via a single platform. This not only enables employees to easily compare one fund to others, but also further facilitates competition between funds. Under Korea’s contract-based governance, the competition seen in Australia would occur between plan providers who manage plan assets. To bring further competition to default options established by plan providers, Korea needs to benchmark the case of MySuper. For default options to take hold, the market needs an objective, transparent competition structure, instead of a rigid investment management regulation for eliminating the risk of short-term loss.
One of the counterarguments against default options without principal protection is the possibility of principal loss. The opponents argue that the risk of principal loss is something intolerable given that retirement pension in nature is a deferred payment and the last resort form of old-age income security. However, such a view could have stemmed from lack of understanding about an investment horizon and the resultant performance evaluation inherent in investment management. Principal loss from investment in risky assets should be divided into two parts, realized and valuation losses. A negative rate of return or a valuation loss is tolerable for an employee with a 10-year investment horizon because a market tends to revert to its mean in the long run unless the expected return on risky assets falls (e.g., a fall in risk premium). A retirement pension is one of the typical long-term investment assets. Although Korean workers’ average service period is quite short compared to other nations, it is undesirable to assume retirement pensions as short-term investment in designing the retirement pension scheme. From a long-term perspective, a loss or gain in value measured annually in risky asset investment is virtual. Of course, a loss or gain in value could be a substantial risk factor for employees with retirement around the corner because for them plan assets accumulated until retirement are no longer long-term assets. What is essential in managing retirement pensions is an adjustment in portfolio. This is why default options mainly use target date funds or other life cycle products with a rebalancing system.
Taken together, principal-protected products in managing retirement pension plan assets serve as a temporary means of storing assets, instead of a long-term investment tool spanning a life cycle. This means that it is inappropriate to include a principal-protected product in the QDIA. It is worth learning from Japan’s unsuccessful experience of introducing default options. Japan’s QDIA includes principal-protected products, and more than 75% of default options are invested and managed by principal-protected products. Default options should consist of investment products that include at least a certain portion of risky assets. The question here is risk management, in other words, how to control and manage the amount of risk tolerable. In asset management, risk is not something to avoid. It should be viewed as a resource that should be properly controlled and used. The amount of available risk here means the size of return that can be produced. In asset management, a shortfall constraint is a means of measuring and controlling risk. For example, a portfolio can be built with its probability of a negative annual return constrained at less than 10%. Such an investment portfolio could incur a valuation loss once in a decade. In another risk management tool, the maximum size of loss could be contained within a certain amount if a negative return occurs (e.g., value at risk). It is important for default options to include financial products that could provide reasonable levels of expected returns by using diverse risk management tools for controlling risk at the level tolerable for different age groups.
Conclusion
Given that the bills for introducing default options were automatically scrapped without sufficient discussion at the end of each session, the discussion about the revision bill taking place in the committee in the 21st National Assembly is arguably encouraging. But the current discussion is still at a nascent stage of exploring the feasibility. The feasibility and necessity have been sufficiently tested and discussed by international organizations and relevant experts for a long time. Now is the time to move on to the next step for formulating concrete action plans and oversight systems that could minimize side effects and maximize expected outcomes. What is critical during the process would be the role and say of financial institutions who currently serve as retirement pension plan providers. Retirement pensions are not an issue trigger for financial market development. It has critical importance in post-retirement income security. Too much concern about the potential gains and losses across different financial subsectors could lead to a misstep, which is undesirable for the pension reform.
1) Some suggest a five-pillar pension system including housing, land and other pensions on the fourth pillar.
2) For example, Adele Atkinson (2012) analyzed the long-term effect of the financial literacy program for corporate pension members in the UK, and found no significant relationship between the completion of the program and changes in investment behavior (Atkinson, A., Messy, F.A., 2012, Measuring financial literacy, OECD Working Papers on Finance, Insurance and Private Pensions).
3) The revision bill proposed by Representative Ahn, Ho-young and others (Jan. 21, 2021), and another bill proposed by Representative Kim, Byung-wook and others (Feb. 2, 2021)
4) Also included in the bill are measures to mandate the establishment of the plan asset management committee, and the documentation of the investment policy statement (IPS), and to permit discretionary investment management for managing plan assets.
It has been 16 years since the retirement pension scheme has been adopted in Korea. The policy objective behind the scheme was to bolster employees’ pension right that had been insufficiently protected by the previous severance pay scheme. The pension right here physically refers to protecting employee benefits against plan sponsors’ bankruptcy by mandating the sponsors to deposit their share of contribution outside the firm. In a broader sense, the pension right means the retirement pension scheme playing a greater role in securing post-retirement income for employees. That line of policy objectives—viewing retirement pension as a policy tool for bolstering post-retirement income—should be the criterion in assessing the appropriateness of many pension reform plans currently being discussed primarily by the Ministry of Employment and Labor.
Most economies with a developed pension scheme including Korea have institutionalized the retirement pension scheme by mandating individuals to save for post-retirement life, rather than leaving it to the discretion of individual employees. This is based on the widely-held perception that individual rationality is limited so that it could be hard for each individual to fully prepare for post-retirement life in advance. In line of that perception, DB plans whose retirement benefit is defined in advance appear to fit better to the intended purpose of the retirement pension scheme. However, many firms tend to shift away from DB plans towards DC plans for prudential and other reasons. A great number of social welfare experts have expressed concerns about the tendency that could dilute the scheme’s intended purpose of securing post-retirement income. From the behavioral economics perspective, DC plans have a structural flaw. According to international organizations such as the Working Party on Private Pensions (WPPP) or the International Organization of Pension Supervisors, such a flaw could be addressed by institutional fixes such as hybrid plans and default options to be discussed in this article.
Against the backdrop, this article tries to explore the meaning and necessity of default options in DC plans, with a review on the revision bill on the Act on the Guarantee of Employees’ Retirement Benefits (the Act, hereinafter) currently pending in the National Assembly. With the super-low interest rate lingering further, long-term investment in principal-protected products is completely unfit for the retirement pension scheme’s intended purpose. This article tries to present a reasonable way to set up default options from the long-term investment perspective by assessing the actual meaning of the risk of principal loss, one of the concerns often mentioned by opponents of default options.
DC plans
Bracing for rapid population aging, OECD has long underscored the importance of building a multi-pillar pension system that consists of a combination of the public pension scheme often mandated by law, and the private pension scheme voluntarily chosen by individuals. In Korea, the public pension scheme including the basic and national pension systems constitute a zero pillar and the first pillar, whereas the second pillar refers to the retirement pension scheme and the third pillar to the private pension scheme such as individual pensions.1) However, Korea’s retirement pension, except for individual retirement pensions (IRP), is compulsory to almost all wage workers, which makes it similar to part of the public pension. Although diverse perspectives on social welfare such as public pension should be accepted, the public aspect should be a priority in discussing the appropriateness of government policies.
The essence of the retirement pension scheme lies in a mandated system where a nation obligates private sector firms to take some responsibility for their employees’ post-retirement life that is in the private sphere. In that sense, DB plans would serve better for the nature. By contrast, DC plans appear to have a logical flaw: Despite the mandated subscription on the reason of the short-sighted and irrational nature of individuals, DC plans emphasize those individuals’ capability and responsibility in managing plan assets. The pension system has evolved differently across nations, but what’s common in most nations is the lack of investment capability among individual plan members for managing their long-term investment such as retirement pension plans. Nations with a developed pension system have consistently shown that policy effort such as publicity or education programs cannot address or ease the issue of individual investment capability in DC plans.2)
This is why most nations with a developed pension system view default options as an essential element to DC plans. Default options are the most effective institutional means that helps address behavioral economics biases inherent in DC plans. In other words, providing DC plan members well-designed default options is the basic responsibility of a nation that mandates retirement pension. Korea’s current condition of retirement pension empirically shows that without proper default options, most of the DC plan assets would sit idle and remain uninvested.
Under the super-low interest rate environment, quite a few DC plan members keep rolling over 1-year time deposits. Some view this as a result of those members’ voluntary, risk-averse behaviors, which is inappropriate. With the interest of time deposits falling far short of inflation, the high proportion of time deposits should be interpreted as investors’ ignorance or inaction, instead of their investment decision. Of course some of the time deposit investors must have willingly placed their assets in those products because of their extreme risk aversion tendency. What’s important in building a concrete execution system for default options is to prevent this type of investors from investing in risky assets against their risk appetite. This would be possible by properly informing investors about how their assets are invested and managed under default options, and by requiring them to regularly review their investment instruction.
Issues worth considering in designing default options
Recently, the Environment and Labor Committee in the National Assembly has been reviewing the revision bill on the Act on the Guarantee of Employees’ Retirement Benefits, proposed for introducing default options.3) Similar bills were already proposed and submitted by the government and other lawmakers to the committee during the 19th session several times. However, the session ended without sufficient committee discussion, and those bills were automatically scrapped. The currently discussed revision bill focuses on the plan to introduce default options in DC plans under the name of “prior investment management designation”.4) However, the bill is currently pending in the committee amid concerns about the possibility of legal disputes over the risk of principal loss from default options that usually come without principal protection.
The key policy issue to be addressed towards default options is who sets up the options, which will be closely related to who is held liable for potential legal issues in the future. This is also part of reasons hindering the introduction of default options in contract-based governance. Under the currently discussed revision bill, default options are set up by financial institutions (plan providers), instead of employers (plan sponsors). Simply put, an investment manager—a retirement pension plan provider—designs default options based on predefined criteria and presents them to plan members after acquiring approval by the Employment and Labor Minister. In the US, it is the employer who sets up default options. It is well-known that the pension reform providing employers immunity from litigation related to any loss from investment-linked default options gave a boost to the adoption of default options. Korea should give plan providers such immunity, with some product design criteria—similar to the Qualified Default Investment Alternatives (QDIA) in the US—being part of the Employment and Labor Minister’s approval.
In trust-based governance in Australia, retirement pension funds are the one who sets up default options. Australia’s superannuation allows individual employees to opt for a specific fund. Competition between funds is known as a key driver for pension development. The point of the competition lies in default options set up by individual funds. Given that over 80% of employees opt for default options in managing their plan assets, a retirement pension fund’s solid and stable return on its default options can serve as a competitive edge. Australia has adopted MySuper that replaces existing default options since 2011 in the nation’s move for facilitating competition among funds. By limiting fee levels, MySuper improves the quality of default options. Under the system, one fund is allowed to set up only one default option while being mandated to disclose its asset composition, performance, and other standardized details via a single platform. This not only enables employees to easily compare one fund to others, but also further facilitates competition between funds. Under Korea’s contract-based governance, the competition seen in Australia would occur between plan providers who manage plan assets. To bring further competition to default options established by plan providers, Korea needs to benchmark the case of MySuper. For default options to take hold, the market needs an objective, transparent competition structure, instead of a rigid investment management regulation for eliminating the risk of short-term loss.
One of the counterarguments against default options without principal protection is the possibility of principal loss. The opponents argue that the risk of principal loss is something intolerable given that retirement pension in nature is a deferred payment and the last resort form of old-age income security. However, such a view could have stemmed from lack of understanding about an investment horizon and the resultant performance evaluation inherent in investment management. Principal loss from investment in risky assets should be divided into two parts, realized and valuation losses. A negative rate of return or a valuation loss is tolerable for an employee with a 10-year investment horizon because a market tends to revert to its mean in the long run unless the expected return on risky assets falls (e.g., a fall in risk premium). A retirement pension is one of the typical long-term investment assets. Although Korean workers’ average service period is quite short compared to other nations, it is undesirable to assume retirement pensions as short-term investment in designing the retirement pension scheme. From a long-term perspective, a loss or gain in value measured annually in risky asset investment is virtual. Of course, a loss or gain in value could be a substantial risk factor for employees with retirement around the corner because for them plan assets accumulated until retirement are no longer long-term assets. What is essential in managing retirement pensions is an adjustment in portfolio. This is why default options mainly use target date funds or other life cycle products with a rebalancing system.
Taken together, principal-protected products in managing retirement pension plan assets serve as a temporary means of storing assets, instead of a long-term investment tool spanning a life cycle. This means that it is inappropriate to include a principal-protected product in the QDIA. It is worth learning from Japan’s unsuccessful experience of introducing default options. Japan’s QDIA includes principal-protected products, and more than 75% of default options are invested and managed by principal-protected products. Default options should consist of investment products that include at least a certain portion of risky assets. The question here is risk management, in other words, how to control and manage the amount of risk tolerable. In asset management, risk is not something to avoid. It should be viewed as a resource that should be properly controlled and used. The amount of available risk here means the size of return that can be produced. In asset management, a shortfall constraint is a means of measuring and controlling risk. For example, a portfolio can be built with its probability of a negative annual return constrained at less than 10%. Such an investment portfolio could incur a valuation loss once in a decade. In another risk management tool, the maximum size of loss could be contained within a certain amount if a negative return occurs (e.g., value at risk). It is important for default options to include financial products that could provide reasonable levels of expected returns by using diverse risk management tools for controlling risk at the level tolerable for different age groups.
Conclusion
Given that the bills for introducing default options were automatically scrapped without sufficient discussion at the end of each session, the discussion about the revision bill taking place in the committee in the 21st National Assembly is arguably encouraging. But the current discussion is still at a nascent stage of exploring the feasibility. The feasibility and necessity have been sufficiently tested and discussed by international organizations and relevant experts for a long time. Now is the time to move on to the next step for formulating concrete action plans and oversight systems that could minimize side effects and maximize expected outcomes. What is critical during the process would be the role and say of financial institutions who currently serve as retirement pension plan providers. Retirement pensions are not an issue trigger for financial market development. It has critical importance in post-retirement income security. Too much concern about the potential gains and losses across different financial subsectors could lead to a misstep, which is undesirable for the pension reform.
1) Some suggest a five-pillar pension system including housing, land and other pensions on the fourth pillar.
2) For example, Adele Atkinson (2012) analyzed the long-term effect of the financial literacy program for corporate pension members in the UK, and found no significant relationship between the completion of the program and changes in investment behavior (Atkinson, A., Messy, F.A., 2012, Measuring financial literacy, OECD Working Papers on Finance, Insurance and Private Pensions).
3) The revision bill proposed by Representative Ahn, Ho-young and others (Jan. 21, 2021), and another bill proposed by Representative Kim, Byung-wook and others (Feb. 2, 2021)
4) Also included in the bill are measures to mandate the establishment of the plan asset management committee, and the documentation of the investment policy statement (IPS), and to permit discretionary investment management for managing plan assets.