Tasks Ahead for Private Pension Development in Korea

Transcription

1 Tasks Ahead for Private Pension Development in Korea Song, Hong Sun Korea should improve its insufficient private pension system in the direction that maximizes the value of pension assets with minimum fiscal support in preparation for population ageing. Fundamentally, such institutional improvement should head toward enhancing public confidence in private pensions. Instead of merely focusing on membership expansion, it is desirable to present a concrete vision for a more systematic structure for managing pension assets and annuitization. An overhaul of the current plan management scheme is necessary to introduce default options and immunity, or create a similar effect by adopting managed accounts. For employees in small to medium businesses, a better approach than a complex hybrid scheme is a NEST pension scheme that pools plan assets to achieve economies of scale. To ensure that annuitization remains in line with the accumulation phase of pension assets, it is necessary to allow annuity products to be embodied in target date funds. In addition, it is wise to induce more pension assets to be annuitized by placing a withdrawal limit from IRP, as does the UK stakeholder pension scheme. Introduction Expectations for public pensions have grown amid baby boomers retirement, sluggish growth in household income, anxiety in retirement readiness, etc. However, public pensions role as a social safety net has been abated by the inverted population pyramid and worsening All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as Korea Capital Market Institute s official position. Ph.D., Senior Research Fellow, Fund & Pension Department, Tel: , dna0214@kcmi.re.kr 1 December 27, 2016

2 fiscal conditions. 1) To tackle the challenge, developed countries have opted to strengthen private pensions as a supplementary tool, and undergone a series of experimental improvements with the aim for increasing private pensions income replacement rate up to 30% within the current constraints in public pension reform. Although Korea unveiled its plan to facilitate private pensions in 2014, the plan lost its drive amid mounting concerns that private pensions might replace public pensions. This makes a sharp contrast to developed countries pension policies that try to supplement the limit of public pensions based on diverse programs designed to induce more private sector savings for minimizing fiscal support in times of fiscal constraints. Korea s private pensions lag behind in terms of both quantitative and qualitative measures. According to the data reported to the OECD in 2015, the OECD average income replacement ratio of public pensions stood at 41.3%, and the ratio of private pensions to GDP at 82.8%, much higher than Korea s 39.3% and 6%, respectively. 2) Such a low share of private pensions compared to the OECD average could be natural given Korea s population ageing and belated move toward a multi-pillar pension scheme. However, this must change going forward. Korea s ageing will progress for the next three to four decades, perhaps at the fastest pace among OECD nations. To establish a retirement safety net on par with developed country levels, Korea should rapidly accumulate private pension assets. In this regard, innovation in the private pension scheme in order to address distrust and lack of confidence in the current one is an important policy challenge toward establishing a retirement safety net. The current distrust and lack of confidence in private pensions are more closely related to the investment management scheme such as low investment returns, lack of transparency, and no clear vision for annuitization, rather than member constraints. Hence, innovation at the current stage must prioritize the investment management scheme, regardless of the type of pension (retirement, personal, etc.). Once the crisis of confidence is substantially abated by improvements in that area, innovation will then gain momentum to expand membership and eliminate the blind spot. 1) Between 2009 and 2015, public pensions income replacement ratio for average income earners moved from 30.8% to 21.6% in the UK, 38.7% to 35.2% in the US, 43.0% to 37.5% in Germany, and 42.1% to 39.3% in Korea (OECD). 2) As of 2015, Korea s private pensions including retirement pensions and personal pensions eligible for tax deductions accounted for 25% approximately. 2

3 Two directions for improvement Korea s private pension plans (personal and retirement pensions), excluding DB plans, are self-funded plans (DC, IRP, and other personal pension plans). Not all private pensions should be self-funded, but self-funding has been by far the most commonly used for private pensions. The largest dilemma in the private pension scheme is that the smaller the blind spot becomes, the lower the members financial literacy gets. Even if the members have high financial literacy, many irrational elements are involved in investment decisions as behavioral economics implies. Accordingly, developed countries that have a sizable private pension market are bombarded with a vicious cycle where plan members get disappointed about low investment returns and how their assets are managed, and eventually become indifferent about their own plan assets. The problem has been viewed as the most serious setback for private pension facilitation as developed countries including the US, the UK, and Australia introduce mandated occupational pensions or an automatic enrollment system. Developed countries have shown two institutional approaches to this problem. One is the government accepting the limit of financial education and adopting default options. The other is pooling plan assets altogether so that a professional asset management company can manage them and allocate investment returns to plan members. At least for now, default options are more widely used, with the increase in experimental programs such as hybrid pensions pooling plan assets. As both approaches have their own merits and demerits, the government should review both carefully given its policy, philosophy, and member characteristics. First alternative: Fiduciary liability in default options at issue Default options are a scheme where a fiduciary automatically invests plan assets that a member is unable to or unwilling to manage in government-approved default products. But the scheme has a drawback where the fiduciary is not immune from liabilities when default products underperform. Hence, the success of default options depends on how to give immunity protections to fiduciaries. Developed countries where default options prosper mainly rely on two tools; direct regulation, and product innovation (market discipline). The US explicitly states immunity protections in law, whereas the UK uses regulation and Australia turns to market discipline. What is intriguing is the US s approach to include immunity protections in law because plan asset managers are subject to strict fiduciary responsibilities 3 December 27, 2016

4 in the US. However, those protections are granted only under rigid requirements. Basically, the automatic enrollment process for default options must include the notification of product information, suitability, and key elements of fiduciary responsibilities during solicitation. As the law mandates automatic enrollment, prior notice about automatic enrollment must be provided to plan members. And the notice must be clearly stated, and include key information about default options (in Korea, key investment information is given to comply with the duty to explain). Of course, plan members can cancel default options any time to replace them with other products. A fiduciary meeting those requirements is deemed as fulfilling the fiduciary duty in the solicitation process, and thus immune from any liability arising from underperforming default options. UK regulation mandates contract-based personal plans with default options to face a prior consultation requirement as is the case in the US, whereas trust-based retirement plans are subject to no regulation except for market discipline that recommends a similar process during the automatic enrollment. Although laws and regulations provide immunity protections, financial firms are highly sensitive to any dispute arising from underperforming default options. The immunity would protect them from legal liability, but not from other problems such as legal uncertainty, lost confidence, or tarnished reputation. This is the very reason behind the rapid progress of innovation in default options. Currently, innovation is taking place in the direction that minimizes the possibility of underperforming default options. Although conservative income funds or asset allocation funds were the majority at the early stage, 3) target date funds and managed accounts are increasingly used in default options these days. Apart from the discussions about introducing default options, Korea has reviewed using managed account services in retirement and personal pensions. In discussions about adopting default options in retirement and personal pensions, Korea is known to have concerns about a potential conflict between the member engagement requirement for investment choices in trust-based plans, and the solicitation regulation under the Financial Investment Services and Capital Markets Act. The legal principle behind immunity works well in the US despite its stronger fiduciary responsibilities, but not in Korea. This may reflect the differences in the legal environment between two countries. 4) However, a higher level 3) Principal guaranteed funds are available for default options, but only for 120 days. They are allowed only temporarily while investments are transferred from one to another product. 4) Whereas Korea tends to be strict about interpreting and implementing the duty to explain without the explicitly stated fiduciary duty, the US tends to understand the fiduciary duty from the view of substance over formality, without any provision on the duty to explain. 4

5 of flexibility is required when applying solicitation regulation to default options amid when the growth in non-face-to-face channels call for a change in how the duty to explain is used. Nevertheless, Korea s enrollment process in private pensions seems more favorable to default options, as compared to the US. With the introduction of automatic enrollment, developed countries are losing their point of contact with clients even during the enrollment process, and thus shifting toward a prior notice. By contrast, Korea s enrollment process still provides points of contact where clients are asked for their investment appetite and given the prospectus for default options, e.g., labor-management negotiation in retirement pensions, mandatory face-toface enrollment in personal pensions, etc. This could provide a means of balancing between the existing solicitation regulation and default options. If this is not sufficient to adopt a safe harbor clause, another option is to introduce managed account services Korea has been considering, which could effectively bypass the immunity issue while creating the same effect as default options. Second alternative: Asset pooling for higher returns Pooling plan assets of all members could achieve economies of scale and address the inconvenience and inefficiency arising when members without financial knowledge directly manage their own plan assets. Although no Korean private pension scheme has used that method, the exactly same structure has been commonly adopted by public pension pools that collectively manage public pension funds, or common funds that manage private school funds. Among private pensions, the UK s NEST pensions are a prominent example of such arrangement. NEST, a workplace pension scheme for low-income earners, has attracted the most attention after the adoption of automatic enrollment. The core benefit of NEST lies in its low cost structure that pools all plan assets first to invest in equity, real estate, debt, etc. The scheme is also subject to fee regulation. Taking the form of target date funds, NEST is imposing a significant impact on default options in the existing private pension scheme. Pooling such as NEST is distinguished from hybrid pension schemes that prosper in developed countries, e.g., collective DC plans, cash balance plans, target benefit plans, etc. Hybrid pension schemes are designed for multiple policy objectives, besides NEST s pooling for lowering costs, and thus more complicated and instable. Although the objective varies, hybrid schemes basically pursue risk sharing for employers in DB plans and employees in DC plans, and other purposes 5 December 27, 2016

6 such as target benefits and annuitization. 5) In 2014, Korea unveiled its plan to introduce a retirement pension scheme for SME employees as part of its drive for facilitating private pensions. Although the concrete structure for the SME retirement pension fund has yet been formulated, the fund is likely to take the form of a personal pension scheme, rather than annuitization, designed for easing the burden of employees, eliminating the blind spot of private pensions, and efficiently accumulating assets of SME employees. Given such objectives, a NEST-like collective scheme that pools plan assets for lower costs and tax benefits would be a more meaningful alternative than a self-funded defaultoption scheme or a complex hybrid scheme. Embody annuity products in default options For lifetime utility maximization, it is the most reasonable choice for a rationale individual to decide its saving level for a stream of lifetime consumption, and to purchase an annuity sufficient to address post-retirement needs and longevity risk. However, as the pension puzzle suggests, life annuities are not very popular. Not to mention DC plans, only about 30% of DB plans with a lump-sum option are annuitized. Although the low level of annuitization results from individual decisions, it could lead to social problems such as elderly poverty and increased fiscal burden. Hence, it is a common policy direction among countries with a developed pension system to place a direct or indirect limit on lump-sum withdrawals of plan assets. For example, the UK places a 25% cap on taxfree lump-sum withdrawals, while the US imposes tax penalties on early withdrawals. This is because the actual benefits of annuitization is a meager compared to lump-sum withdrawals, and because IRP accounts can be closed freely during job separation. Although IRP accounts can be opened directly between an employee and a financial institution unlike DB and DC plans, they are subject to tax benefits under the Act on the Guarantee of Workers Retirement Benefits, and thus it would be problematic to allow those accounts to be opened and closed freely. The UK stakeholder pension scheme has a contract-based private pension structure that has similar features to Korea s IRP, but it places some restrictions. Withdrawals are restricted 5) However, hybrid schemes could create ambiguity in who bears the ultimate risk, and other problems in traditional DB plans, e.g., shifting burdens to future generations due to longer life expectancy and lower investment returns, transferring wealth from the low-income to the high-income class due to different life expectancy across classes. Nevertheless, the UK, Canada, and other countries have adopted hybrid schemes and continued their experiment on improving the pension system. 6

7 until a member turns 55-year old, and lump-sum withdrawals only up to 25% of plan assets are without tax penalties. On the other hand, it would be almost impossible to completely limit lump-sum withdrawals unless annuitization is embodied in the pension scheme. An unconditional limit on lump-sum withdrawals would not only excessively undermine individual freedom of choice, but also run counter to incentive compatibility. To tackle this issue, financial innovation is recently shifting toward a product design inducing plan members to pursue annuitization based on the market principle. Including annuities in target date funds to be used for default funds is a prominent example. This requires a target date fund that matures after retirement. Currently, the market size for such funds exceeds 30% of the total market, suggesting ripe market conditions for including annuities in the latter part of the accumulation phase. Including annuities in target date funds will have the effect of lengthening the accumulation phase (increased risk bearing), and thus increase investments in risky assets over the lifecycle. From the demand perspective, this will address the inconvenience of purchasing pension products again after retirement, reduce the costs, and thus create the effect of market expansion. Among others, including annuities in pension asset allocation would increase the rate of annuitization and enhance individual responsibility for retirement income stability. Toward such innovation, funds should be able to include annuity products based on full compliance with the fiduciary duty. The US case can provide a good reference in this area. Conclusion As described above, the Korean public pensions income replacement rate hovers around the OECD average, whereas that of private pensions falls far short. Hence, Korea needs to develop its private pension scheme that helps increase private plan assets to the highest level possible. Toward that end, the focus of institutional improvement should shift away from membership expansion toward higher confidence in private pensions based on a solid vision for annuitization and a systematic regime for plan asset management. Improvements are necessary for private plan assets to introduce not only default options, but also immunity protections for fiduciaries and managed accounts that will in effect serve as default options. For small business workers, a scheme similar to NEST works better for achieving economies of scale, instead of individually managed default options or complex hybrid schemes. Desirably, annuity products should be 7 December 27, 2016

8 embodied in target date funds so that annuitization is linked to the accumulation phase. Also necessary is a restriction in withdrawals from IRP accounts as is the case in UK private pensions, which is expected to induce more retirement pensions to be accumulated for retirement readiness. 8