Public Pension Funding Scheme and Proposed Reform
2023 Aug/22
Public Pension Funding Scheme and Proposed Reform Aug. 22, 2023 PDF
The debate on public pension reform is in full swing in South Korea. Although everyone agreed on the need for reform, it is still uncertain whether actual reform can be carried out. The five-year delay in pension reform has brought forward the expected fund depletion of the public pension fund by two years, and increased the contribution burden for the future generation by 1.5 percentage points. By 2055, the fund will run out completely, and the scheme will be converted to a full pay-as-you-go system. Without any reserve accumulated in the fund, our future generation will have to bear the contribution rate as high as 26.1%. Intergenerational equity should be considered in public pension reform that is designed for intergenerational support. Because the proposed reform is premised on the fund's depletion and the resultant transition to a PAYG system, it is hard to expect it to alleviate intergenerational conflict. Behind the reform lies the declining and aging population.

Developed nations with advanced welfare systems that once boasted their full PAYG system are now struggling to accumulate a buffer, which is found in a funded system. In general, a PAYG system is more vulnerable to demographic changes than a funded system. This has become a fundamental reason behind intergenerational conflicts over the pension system. Korea's pension scheme (NPS) currently has a reserve amounting to KRW 1,000 trillion. This gives Korea an edge to redesign its funding system that maintains a certain level of reserve permanently, instead of a forced transition to a PAYG system due to depletion. Such partial funding means a steady state model successfully adopted by the Canadian pension fund. It is possible for Korea to shift towards the steady state model if it raises premiums to a tolerable level and improves investment returns to a reasonable level. It is an opportune moment to remind ourselves of the true meaning of social solidarity emphasized by the public pension.

Public pension reform is under heated debate by the government and the National Assembly. Despite public resistance to public pension reform and the resulting political burden, the political sphere is now pressured by the opinion that this is a task of the times that can no longer be postponed. It means that the atmosphere is ripe for reform. However, many still appear to doubt if this round of reform achieves substantial results. This is because pension reform is one of the toughest policy challenges as it requires concessions and compromises between generations. The National Assembly Special Committee on Pension Reform (the Committee, hereinafter) finished its first session without coming up with any plausible alternative to parametric reform, and the responsibility is now on the government.1) The Committee decided to shift its priorities from parametric reform to structural one. The second expert advisory panel aims to continue discussions on the overall public pension system including basic pension, with continued public debate.2) However, neither parametric nor structural reform precedes or counts than the other. This is because reform proposals can only be presented as a package.

Regarding the parametric reform represented by higher contributions, it is getting increasingly difficult to reach social consensus on any solution that presupposes pension depletion and a transition to a PAYG system when discussing the sustainability of the public pension system. The problem lies in the funding scheme of public pensions.3) Advanced welfare states that once boasted a full PAYG public pension system are now exerting efforts to accumulate reserves that could function as a buffer like a funded system on top of their PAYG system. In general, a PAYG system is more vulnerable to demographic changes than a funded system. When population is on the decline, a full PAYG system is hardly likely to ensure intergenerational equity. This has become a fundamental reason behind intergenerational conflicts over the pension system. Korea's pension scheme (NPS) currently has a reserve amounting to KRW 1,000 trillion. This gives Korea an edge to redesign its pension funding system that maintains a certain level of reserves permanently, instead of a forced transition to a PAYG system due to depletion. Such partial funding means a steady state model successfully adopted by the Canadian pension fund.

To support the claim, this article first explores public pension's funding system. There are two types of pension funding: PAYG and funded systems. The funded system is again divided into fully- and partially-funded schemes depending on the funding level. Korea's NPS is classified as a partially-funded public pension. This article shows why it is difficult for Korea to pursue a fully funded system although this is a universal funding approach of public pensions. For this, it explores the cases of advanced welfare nations that are strengthening the funded function in their PAYG system. Based on this, this article aims to present a desirable direction of institutional reform from the case of the Canadian model where the funds required for benefit payouts are covered by premium income and investment returns. In conclusion, this article seeks to discuss institutional reform, and to highlight the need for funding system reform that will enhance investment returns.

Public pension funding systems

For sustainability of a public pension system premised on permanent existence, a long-term balance is a must in pension funding. The long-term balance of pension funding means that the present value of all future expenditures is equal to the sum of the present value of all future income and the funds accumulated up to that point. There may be various funding methods for public pension, but all of them must satisfy this long-term financial balance. Thus far, the PAYG scheme has been regarded as a universal funding system for public pension in welfare states. This is because the premise of public pension lies in a social contract where the government mandates public assistance and intergenerational support.

A PAYG system uses the premiums paid by the working generation as the source of benefit payouts to the retiree. Under that system, the premiums paid by each individual are used for benefit payouts to other pension members, instead of being accumulated separately.4) In a PAYG system, expenditures are mechanically same to revenues. Unless some part of revenues is set aside as reserves, income in a PAYG system means the sum of the premiums paid by the members at a certain point of time. All costs necessary for benefit payouts rely entirely on premium revenues, and the required premium rate at this point is referred to as the "PAYG cost rate. According to the fifth actuarial valuation of the NPS, the projected PAYG cost rate reaches as high as 26.1%.5) This means that future generations will have to pay more than 26% of their earnings as premiums after NPS depletion.6) This is not an affordable level, taking into account other premiums for occupational and social pension plans, and others. Fund depletion merely signifies a shift to a full PAYG approach. This is why the Millennials and Generation Z cannot fully trust the claim that the promised benefits of public pensions will be paid as long as the country exists.

The NPS is currently in a partially funded status where its funding ratio7) is below 1. The partially funded scheme as a system is generally interpreted as a transitional state in the early stages of a pension system. It is an intermediate phase as the system matures and shifts towards a PAYG one. Such a partially funded state is defined as "scaled premium partial funding" where the reserves are maintained only for a certain period of time. Under that state, pension depletion is inevitable, and the accumulated reserves are only a means to delay the point of depletion. Therefore, if the benefit level is fixed, the primary policy variable for funding stabilization is the adjustment of insurance premiums. The investment returns on the accumulated reserves are treated as exogenous variables that cannot be targeted through policy. However, it is very difficult to achieve any social consensus on the alternative to parametric reform presented on the premise of depletion. If enduring painful increases in pension premiums only results in delaying the point of depletion by a few years rather than achieving lasting stability in pension funding, it would merely increase the fatigue of repetitive reforms. In particular, given that the most important factor in achieving social consensus is intergenerational equity, the alternative to parametric reform presented under the premise of the full PAYG method has fundamental limitations in alleviating intergenerational conflict.

Why has the PAYG system been deemed unsuitable for the future of NPS although this has been considered the prevailing funding method of public pensions? The reason is not simply that the PAYG system leads the current generation to pay less due to the innate structure where individual pension benefits are irrelevant to the amount of one's contribution. The root cause behind the issue is a change in demographic structure. Under the mechanism of intergenerational support, the working generation supports the retiree. But it is difficult to keep the social promise of the public pension if the population of the future generation continues to decrease compared to the current generation. It is a problem of intergenerational conflict that has come to the fore in public pensions. This is the reason why advanced welfare states in the West are currently striving to add the funded function into their PAYG pension system through additional contributions from the current generation. This is interpreted as an effort by the current generation to alleviate excessive burdens on future generations because the full PAYG approach could undermine intergenerational equity in an era of declining population.

Enhancing a funded function in PAYG public pensions

One notable example is New Zealand's superannuation fund, which was established in 2001. Although its name might lead to confusion with Australia's retirement pension system, New Zealand's superannuation fund is a type of sovereign wealth fund created by the current generation to alleviate future generations' tax burden for basic pensions. Despite being a sovereign wealth fund, it is referred to as a pension fund because the purpose of its establishment is to secure sources for pension payouts to future generations. This aims to strengthen intergenerational equity by reducing the gap in tax burden between the current and future generations due to demographic changes. The national contribution to the fund every year is set as a percentage of GDP. As of 2023, $24.3 billion of government funding has been injected. Through a strategy aimed at maximizing returns within the reference portfolio framework, the current size of the fund has reached $62 billion. Early withdrawals from the fund are legally prohibited until 2036, and the New Zealand government has announced that there will be no withdrawals from the fund reserves until 2050.

Australia also created a Future Fund in 2006 for investment purposes to supplement pension benefit payouts to future generations. After injecting $60.5 billion in 2006, the fund has achieved a high annual average return of 9.7%. As of 2022, the fund's total assets under management (AUM) have reached $194 billion. The use of the reserve fund was possible from 2020, but the Australian government announced that early withdrawals from the fund would not be made at least 2027. A more relevant example is the National Pension Reserve Fund in Ireland. In response to the aging population and the projected rapid increase in public pension benefit payouts starting from 2025, Ireland established the NPRF in 2001 with the aim of alleviating the burden on future generations. The government contributes 1% of the GNP annually to the fund, and the established reserves are designed to be spent over a minimum period of 30 years, starting from 2025. This is a case of a transition from a full PAYG public pension into a partially pre-funded system.

Yermo (2008)8) presented two grounds for establishing a pre-funded scheme within a PAYG public pension system as follows: It enhances intergenerational equity via tax smoothing and also bolsters the system's payout ability via improved investment returns. This is because public funds of a certain size or larger can secure investment competitiveness by capitalizing on their long-term investment horizon, large scale, and reputation. In particular, it is possible for those funds to generate significant long-term capital income from overseas investment in countries with different levels of population aging. This is evidenced by the fact that most of the pre-funded schemes introduced above set high target rates of return in the upper 6% range.

Division of roles between insurance premiums and investment returns

From the perspective of enhancing the funded function in PAYG public pensions, the NPS's current partially-funded approach is seen as a step ahead: The NPS's reserve fund has already accumulated KRW 1,000 trillion, which is what many PAYG systems aim to reach with additional public funding. This should lead to a new funding approach that maintains a certain level of reserves permanently, without depleting them, in order to mitigate the systemic challenges the PAYG public pension system will face in the era of population aging. A method of steadily maintaining a certain level of funded status to continuously supplement the PAYG cost rate is referred to as "steady state funding". This is a method of public pension funding that was successfully established through the 1998 pension reform by the Canada Pension Plan.

The CPP designed a steady state partial funding approach with a shortened actuarial valuation cycle of three years and a consistent asset/expenditure ratio (5-6 times)9) maintained over the evaluation period of 75 years.10) The structure involves presenting a minimum contribution rate to maintain steady state funding according to actuarial valuation, along with a target rate of return for the management of reserves. At the beginning of the reform, the premium was raised from 6.4% in 1998 to 9.9% by 2003. Considering the difficulties in the premium increase, the key policy variable to maintain steady state level funding in the subsequent actuarial valuation process is the adjustment of the target rate of return in fund management. The target rate of return for the fund managed under the reference portfolio system is known to be in the low 6% range.11) In terms of the PAYG cost rate where contributions and investment returns share the role, it can be understood that 60% of the total cost required for benefit payouts is covered by the premium revenues by future policyholders, while the remaining 40% is covered by the investment returns from the reserve fund.

For a steady state model to be sustainable, the reserves must be maintained above a certain level, and the target rate of return required by the system must be achieved in the long term. To this end, the CPP established an independent investment management body called the CPP Investment Board (CPPIB) along with raising contribution rates in the 1998 pension reform. The CPPIB was established as a highly independent public institution called a Crown Corporation to secure operational autonomy from the government and to recruit top-tier private investment experts. The CPPIB has recently changed its institutional name to CPP Investment (CPPI) to emphasize its status as an investment specialist firm. As a public pension fund management institution, CPPI, renowned for its world-class operational efficiency, has developed a distinctive system called the reference portfolio so as to achieve the mission assigned by the institution. According to the 2022 annual report, CPPI has established a reference portfolio with an 85% allocation to risky assets with the aim to achieve the target rate of average annual return of 6.11%. From this portfolio, it has recorded excellent investment performance exceeding a 10-year average return of 10%.

The NPS could also benchmark the CPP case. Of course, considering the strong path dependency of the pension system, it would be challenging to directly apply the CPP model to the NPS because of different demographic structures, macroeconomic conditions, and investment cultures between the two countries. However, it is possible to refer to the general direction of the reform, which is to prepare for future benefit payouts by maintaining steady state partial funding and dividing the roles between premiums and investment returns, rather than shifting to a full PAYG system. For example, the NPS financial projection committee may try to achieve the long-term financial balance over a 70-year evaluation period by striking a balance between pension premiums, fund investment returns, government funding, costs required for pension payouts, and other expenses, while holding reserves larger than ten times the annual pension expenditures starting from the 50th year to the final year of the evaluation period. This means that the target for steady state partial funding is set at 10 times the asset/expenditure ratio. According to the ALM analysis by the National Pension Research Institute, simulations indicate that a 4% increase in premiums and a 6.8% rate of return on investments would be necessary in order to achieve this steady state condition.12) As mentioned above, a 13% contribution rate is socially acceptable without any further increase. Also, overseas cases suggest that a target rate of return at 6.8% is feasible in practice. Of course, this presupposes that Korea's current fund management system is advanced or specialized to a level similar to that of overseas pension funds. This is the reason why institutional reforms should accompany a reform of the fund management system, aimed at enhancing the management efficiency. In terms of the distribution of responsibilities for future pension payouts, premium revenues cover 34.8% of the total cost, while returns on fund management account for 65.2%. If it is possible to provide fiscal support by allocating 1% of GDP annually for the next 10 years, then the increase in premiums required to maintain the equal steady state condition could be lowered to 3 percentage points, with the target rate of return for fund management as low as 6.3%. This is a matter of choosing between the social acceptability of premium increases and the feasibility of improving returns. The crucial point is that various reform options that are realistically capable of achieving social consensus can be presented to the public during the process of discussion.

Concluding remarks

As reported in the media, the first private expert advisory panel under the Committee failed to reach any agreement on the comprehensive reform proposal. The discussion began in the direction of presenting a single plan for parametric reform, but ended without narrowing the fundamental differences. They could not even come up with multiple alternatives. In terms of the direction of reform, the expert advisory panel was divided into two: One emphasized financial stability and the other strengthened benefit guarantee (income replacement rate). The former focuses on the sustainability of the pension system, while the latter emphasizes the purpose of the social welfare system. However, even if ideas from both sides13) were presented as alternatives to parametric reform, it would have been also difficult to reach a social consensus on any of them. The argument of enhancing the income replacement rate is believed to exacerbate the already serious intergenerational conflict, while the argument for fiscal stability is hardly viewed as fiscal stability as it merely delays the point of depletion by a few years.

A continuous and trending population decline, not a temporary one due to natural disasters or wars, is a situation that mankind has never experienced before. In the era of declining population, the sustainability of a full PAYG system exposes structural limitations. This is well evidenced by the cases of several PAYG public pension systems that began creating additional funds to alleviate the burden on future generations. The partially funded NPS scheme has accumulated a significant level of reserves in its initial stages. It needs to seek the establishment of a steady state model in which a certain level of reserves is permanently maintained. This will help the excessive burden on future generations be distributed effectively through their premiums and the investment returns on the reserve fund accumulated by the previous generation, which is perfectly in line with intergenerational equity. It is time to look back at the true meaning of social solidarity emphasized by the public pension system.
1) As part of the fifth actuarial valuation, the Ministry of Health and Welfare is mandated to submit by October 2023 a comprehensive management plan for the NPS that includes reforms on funding and investment management systems.
2) In pension reform, parametric reform means adjusting institutional valuables such as contribution rates, income replacement rates, eligibility ages, and others within the existing institutional framework. On the other hand, structural reform means making changes in the framework itself, like adjusting the pension's relationship to other plans such as the basic pension, or the values such as the A value (the average earning of the total) and the B value (the participant's own average earnings).
3) In a PAYG system, expenditures in one year are covered by income of the year, without any reserves accumulated. However, a funded system accumulates reserves necessary for future benefit payouts.
4) It is possible to accumulate a certain level of reserves for paying out pension benefits in a full PAYG system. Those reserves sit outside the area of fund management that is based on the rate of investment returns. Hence, the funding ratio of 1–which refers to a funded status that secures benefit payouts for one year–is regarded as a PAYG system, not a partially funded system.
5) This is 1.5 percentage points higher than the result of the fourth actuarial valuation.
6) The PAYG cost rate is the value that divides total benefit payouts into total insurable earnings. The denominator–insurable earnings–is only 30% of GDP. This is because some incomes such as capital income and the income exceeding the upper limit are not deemed as insurable earnings. If all other incomes become insurable, then the GDP cost rate will be a meaningful indicator. The 5th actuarial valuation estimates the GDP cost ratio to be up to 8%.
7) Pension liabilities to reserves ratio
8) Yermo, J., 2008, Governance and investment of public pension reserve funds in selected OECD Countries, OECD Working Papers on Insurance and Private Pensions 15, OECD Publishing.
9) Asset to expenditures ratio of the year
10) Shin, H.Y., Choi, K.H., Shin, S. and Kim, J.H. (2020) Study on the financial evaluation indicators for actuarial review of the public pension, KIHASA Research Paper 2020-40.
11) According to the 2022 annual report of CPPI, the annual average of five-year target returns was set at 6.11%.
12) This assumes a schedule to raise the contribution rate by 0.5 percentage points per year starting from 2025.
13) Those prioritizing financial stability proposed a gradual increase in the contribution rate by 15% while maintaining the income replacement rate at 40%. On the other hand, those supporting the stronger income replacement argued for increasing the contribution rate by 12% and the income replacement rate to 50%.