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2022 Feb/14
Overhauling the DC-type pension scheme for strengthening the old-age income safety net Research Papers 22-03 PDF
The single-tier pension scheme has historically evolved to the multi-pillar system, which can be summarized as a transition from DB (defined benefit) plans towards DC (defined contribution) plans. The US and the UK have focused on pure DC-type plans, while European nations have developed hybrid pension plans combining the characteristics of both DB and DC plans. Regardless of the types, the growth of the DC plan would undermine the old-age income safety net because it requires employees, not the government or employers, to take greater responsibility for the post-retirement income security to support those without the ability to work. Employees should take investment and inflation risks that may be posed in the course of pension assets accumulation. Furthermore, the burden of determining the transition to an annuity and managing longevity risks should be borne by employees. This implies that the DC plan has become mainstream not because it serves as an old-age income safety net but because there are limitations on the growth of the DB plan.
For these reasons, markets, industries, governments, and international organizations have already made efforts for regulatory reform on the DC plan. Mandatory or automatic enrollment into the retirement pension has been widely adopted to overcome the limitations of private pension plans. In addition, a default option or a hybrid pension scheme has been introduced to manage investment risks, and institutional incentives are increasingly provided in an effort to curb the outflow of retirement funds and to encourage the transition to an annuity. These measures have been implemented through monetary incentives or institutional enforcement, albeit to varying levels.
In Korea where DC plans including IRPs account for 40% of pension assets, there are discussions about how to strengthen the function of DC plans as the post-retirement income security, which, however, have not yielded fruitful results. Korea’s retirement pension scheme has an underdeveloped contract-based pension fund governance, complicating discussions for enhancing pension scheme-related institutions.
To remove marginalized groups in the pension scheme, Korea needs to mandate enrollment into pension plans by shifting from the current severance pay scheme towards the retirement pension system, rather than adopting mandatory or automatic subscription selected by advanced countries. Furthermore, the requirements to join pension plans, which are tougher compared to other countries, should be eased to facilitate a more inclusive retirement pension system for the whole nation including the self-employed and non-regular workers in the long run. Recognition of losses and expenses in excess of contributions and direct support for pension contributions should be applied to small business entities with a greater burden of introducing the pension scheme, aiming for creating the long-term virtuous cycle in terms of business management and welfare.
Concerning the pension management reform to improve low returns, the introduction of the fund-type pension scheme may not be efficient for DC plans where plan members have the right to entrust pension asset management. In response to this problem, advanced countries have introduced a default option under which the right to manage plan assets is given to plan providers (experts) if certain conditions are met, or have adopted a hybrid pension scheme that entrusts experts with plan asset management in the pension plan designing stage, as is the case with the DB plan. It is desirable for Korea to embrace both of the two institutional tools to offer options to plan members. Under the circumstances, Korea should consider mandating a default option as Australia, the UK, and the US do, or needs to have an exemption system to show a strong commitment to facilitating default options. It can also benchmark Japan’s pension system for introducing a default option system comprised of investment products to overhaul the principal-protected retirement pension scheme. Furthermore, it should allow competition with the SME retirement pension fund that has adopted a hybrid pension scheme to reorganize the plan providers-driven retirement pension market into the plan members-driven market where plan providers compete for higher returns.
With regard to the annuitization, it is the global standard among advanced countries not to mandate the annuitization for a pure DC plan. Thus, there seems to be no alternative other than to minimize the lump-sum pension withdrawal by offering a wide range of options for plan assets in excess of a certain amount such as programmed withdrawal and a life annuity. However, it is notable that Korea’s low annuitization rate is attributable to the fact that IRPs can be freely canceled, not to excessive interim payments from DC plans. Thus, the IRP cancellation should be limited to the level of advanced countries over the course of pension asset accumulation through policy measures such as a relevant tax regime or withdrawal limits. Moreover, institutional tools should be reformed for promoting annuitization through innovation of products and services including the combination of an annuity and a default option product, innovation of programmed withdrawal, and rationalization of high annuitization costs. As for the SME retirement pension fund that can be collectively operated by hybrid pension plans, it is necessary to examine the introduction of a default annuity to significantly cut down annuitization costs.