It is now just over 5 years since the enactment of ERBSA (Employee Retirement Benefit Security Act) which introduced corporate pensions in the form of funded Defined Benefit plans, Defined Contribution plans and Individual Retirement Accounts to replace the existing severance schemes. Since then, over 94,000 corporate sponsors have adopted the new system and total corporate pension assets now exceed KRW 29 trillion ($20bn). In particular, 2010 was considered a significant year in the future of corporate pension market of Korea as existing tax benefits on legacy severance pay schemes were phased out.
More than KRW 15 trillion flowed into corporate pension schemes in 2010. Furthermore, the ratio of large scale companies adopting retirement pension system has noticeably increased. This in turn has changed the competitive landscape with dynamic shifts in service provider rankings as well as by industry sector, where the banking industry has gained market share while the insurance sector has lost market share. Many of the most recent adopters of pension schemes have opted for DB plans.
Another key development was the Financial Supervisory Service (FSS) crack-down on excessive competition via abnormally high fixed interest rates on savings products or insurance GICs. This was achieved by the introduction of ‘enhanced supervision of risk management for high-return guaranteed vehicles’ in May 2010. Despite these measures, sponsors and members remain conservative in their investment choices, preferring bank term-savings and GICs over investment trusts and fund products.
Despite significant developments, data on pension providers and pension products are not easily accessible or comparable across industries, making it difficult for sponsors to adequately assess their options. 2010 was expected to be a “trigger year” for plan adoption, but HR and Benefit managers still struggle to get clarity on service providers and the underlying investment products they offer on their platforms, and many have delayed adoption. Data is spread across a wide number of sources due to the dynamic nature of the industry, where almost all types of financial entities from banks to insurers to brokers to fund managers have a stake in the market.
At year end 2010, over 94,000 companies had applied for the scheme representing coverage of over 2,227,000 employees. The new system was introduced to encourage companies to reduce internal funding, increase external funding levels and encourage long-term savings by placing limits on early withdrawals. Another significant change is the introduction of additional payment options whereby employees can choose between lump-sum or pension annuity payments, with measures to encourage the latter over the former.
Unlike corporate pension plans in the West which are based on trust law and incorporate the concept of a fiduciary, Korea’s retirement pension system works on the basis of a series of contractual agreements with various financial entities that operate as service providers. Service providers are divided into two main categories -the Plan Administrator and the Asset Administrator. Corporate sponsors may opt to choose the same or a different service provider for each type of contract, and may even select multiple service providers.
There are a variety of structures that can be put in place and the sponsor may determine the number and type of providers as well as the overall service provider structure. In a “bundled” service arrangement, the main contract is with the Plan Administrator who often performs the dual function of Asset Administrator. This has the advantage of creating a single point of contact and making the overall structure easier to manage. The structure is simple with fewer conflicts between providers which facilitate more rapid decision-making and smoother operations. However this can also result in lack of flexibility and investment choice -service providers have a tendency to stick with products they or their affiliates are currently offering.
In an “unbundled” service arrangement, it is possible to use different providers for the role of Plan Administrator and Asset Administrator, and indeed match one or more Plan Administrator with multiple Asset Administrators. In general, service providers prefer a bundled service arrangement as this reduces their hassle and also increases their fees. Service providers will therefore naturally emphasize the advantages of a bundled arrangement. However, in our experience Sponsors who are more concerned about investment issues may be better off in an unbundled structure which offers greater flexibility and investment options and is at less risk of being dominated by a particular provider’s own products.
DB and DC plans are subject to different investment regulations and guidelines, especially regarding asset allocation to ‘risky assets’ and offshore investments. In general, investment guidelines for DC plans are more prohibitive relative to DB plans.
Recent changes to pension regulations
In recent years, the retirement pension market has been extremely active with intense competition amongst the larger service providers. This is in contrast with actual growth in pension markets where the growth in assets has been decent, but not as high as originally hoped, due to the propensity for Sponsors to offer interim settlements and lump sum retirement pay for legacy severance schemes. The government has recently introduced changes to the existing regulations based on feedback from market participants on how to promote growth in pension market and prevent over competition among the service providers.
In addition to revisions of ERBSA implemented in 2010, the government is pushing an agenda to revitalise the pension market in order to adequately prepare for the aging of the Korean population by broadening sources of old-age income and reducing dependency on the National Pension. A number of regulatory changes are scheduled for 2011 as part of this ongoing reform agenda. The 2011 improvement plan announced by the Financial Supervisory Service and the Ministry of Employment and Labor can be divided into two categories; regulations dealing with Service Providers and regulations dealing with Sponsors and Members.
●Limits on the inclusion of the service provider’s own products
There is currently an unhealthy weight toward “principal-and-interest-guaranteed” products which are usually the service provider’s own products -banks with their savings products, insurance companies with GICs and Securities houses through ELS. Going forward, limits will be imposed on the allowable ratio of a given service provider’s own or affiliate products
●Greater disclosure on service provider performance
Disclosure requirements on investment returns are currently quarterly and at the total return level only. The new requirements will seek monthly reporting of investment returns and split the component of returns into two buckets - one for principal-guaranteed and one for return-seeking products.
●Clearer guidelines around unacceptable sales practices
New regulations will spell out the practices that are deemed unacceptable and should include limits on excessive underwriting of costs, provision of tangible/intangible economic benefits, or offers of non-pension related favors. Hosting seminars or informational events or offering consulting on operation, accounting, tax issues will still be allowed.
●Tougher registration requirements for Plan and Asset Administrators
In order to improve the quality of pension services, the government is seeking to strengthen licensing requirements so that service providers must meet certain headcount or professional requirements (no. of actuaries or investment consultants, operations, education, systems etc.) and pass periodic reviews to retain their license. This may result in a natural selection process whereby the smaller service providers may decide to discontinue their Plan Administrator license and focus instead on the Asset Administrator side of their business.
Sponsors and Members
●Relaxation of investment restrictions and limits on risky assets
This applies primarily to DC and IRA schemes. The key will be around the 40% rule which currently restricts any collective vehicle from owning more than 40% in ‘risky assets’. The new restrictions will allow up to 40% in risky assets for the overall portfolio rather than at the underlying vehicle level. This means that equity funds and balanced equity funds will be allowed. However, investments in direct listed stocks will continue to be restricted. Restrictions for DB remain largely unchanged, as the current limits are deemed flexible enough (equities capped to under 30%, equity balanced funds limited to 50%). We believe this change will contribute to a significant expansion of investment choice for members.
●Extension of tax benefits with income tax deduction
Under the current system, DC member contributions and personal retirement savings are treated equally and lumped together as one bucket when calculating tax deductions. In order to encourage greater participation, the government may seek a separate and distinct tax deduction for retirement pensions.
●Greater incentives for pension payments as opposed to lump sum
The government is also exploring measures to promote pension payments over lump-sum, largely through tax reform and the offer of favorable tax treatment for pension payouts.
Corporate pension adoption rates
In 2010, around 24,000 joined the ranks of companies that have adopted corporate pension plans, which currently stands at around 94,000 in total. For the top 1,000 companies with over 500 employees, adoption rates are close to 60%.
The number of plan adoptions is greatest for IRAs. This reflects the fact that smaller firms with fewer employees and pension assets have a tendency to adopt DC or IRA. However, the number of DB plans adopted is also quite significant.
Service providers in all four industries have seen substantial growth in pension assets, with the highest rates of growth for securities (185%) followed by general insurance (170%) and banking (113%), and life insurance coming in last (62%). Market share by industry type remains highest for banks and life insurers, but securities firms and general insurers closed the gap in 2010.
There are noticeable patterns in the concentration of DB vs. DC plan assets by industry. Banks have the greatest aggregate assets across all types of schemes, with DB plans taking up the largest portion. Securities companies, on the other hand, have been more focused on DC, the notable exception being the recent and significant increase in DB assets due to the addition of Hyundai Motor Company’s pension plan which was awarded to affiliate HMC Investment Securities. As a result, DB market share for the securities industry grew from just 9.1% in2009 to 14.6% in 2010. In the case of both life insurance and general insurance companies, assets are predominantly concentrated in DB.
DB schemes are heavily weighted toward principal guaranteed products. Ironically, DB assets are invested in a wider range of products relative to DC or IRA due to fewer restrictions on investments. Indeed, the lack of diversification within DC/IRA schemes is a concern, with the majority of assets invested in cash or bond/bond balanced funds and virtually no allocations to equity funds or alternatives. This will continue to be the case until investment restrictions on DC/IRA schemes are relaxed.
Among the four industry categories, securities firms show the highest weightings (15.4%) to fund products managed by external fund managers. However, even this figure is only half of what it was last year. The increased conservatism in terms of product allocation can be explained partially by the significant increase in DB assets over DC. In general, DB sponsors have a greater propensity to seek out principal-guaranteed products rather than return-seeking products. Insurers will also tend to offer variable insurance in lieu of investment trusts, although many of these products are actually wholly or partially sub-advised by external fund managers.
In aggregate, nearly 56% of total assets are invested in cash instruments, albeit at higher guaranteed rates than current market rates on average. The total proportion of pension assets allocated to principal-guaranteed products is 88%, with less than 7% invested in return-seeking vehicles. This is indicative of the “cash reserving” mentality that sponsors applied to their legacy severance schemes, where the key focus was capital preservation rather than income or return generation.
Allocations within return-seeking products
Within return-seeking products, bond and bond balanced funds, that invest less than 40% in equities, account for the majority. Pure equity investments are insignificant. This is partially driven by DC investment restrictions that limit allocations to equity or equity balanced funds resulting in aggregate exposures of less than 5% to equity related products. Variable insurance accounts for 8% of assets and has not seen much traction in gaining assets.
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