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September 2007 - Korea’s pension and investment market has been through some fairly rough times, but as we reported in the April edition of IPA, the introduction of the Employees Retirement Benefit Security Act, or ERBSA, at the end of 2005, ushers in the beginnings of a new era. The early signs have confirmed what many predicted, that Korean companies would be slow to embrace the new system; but momentum is building. At the same time, the investment policy of the Government run National Pension System is being modernised, and the sovereign wealth fund, the KIC, is rolling out its own distinct allocation policy. Foreign asset managers are being encouraged, as never before, to demonstrate how they can help Korean institutions develop their experience of global investing across all assets classes.

As Hewitt’s Carl Redondo observed in our April report, prior to the ERBSA, all companies in Korea provided retirement benefits in line with mandatory DB rules. The system is very inflexible and the only variation between companies is whether they follow the mandatory rules or use a more generous benefit formula - for instance, providing two months instead of one month of final pay for each year of service. ERBSA has changed a lot of this. It has brought a lot more flexibility over the types of pension plans that can be used - in particular introducing the concept of DC plans. There are still mandatory rules over the minimum benefits that must be provided in a DB plan (or contributions that must be paid to a DC plan) but beyond that almost anything is permitted.

ERBSA has also brought stricter funding rules. DB plans must be funded to a minimum level of 60% of the liabilities and DC plans must be fully funded. The key aim of ERBSA is for companies to review their current retirement plan and convert

it to a new “ERBSA approved” retirement plan. The government is targeting the end of 2010 for all companies to have converted to a new plan.

ERBSA specifies a minimum employer contribution rate of 8.33% of salary to DC plans and companies will have to use this minimum as the starting point for plan design. Benefits will be paid to employees whenever they leave service (there is no concept of a specific “retirement age”) and the default format is to pay the benefits as one lump sum. Equity investment is limited to 40% of an individuals DC fund and this can only be invested indirectly. Apart from this, employers/employees have freedom over how to invest. The legislation includes some minor tax incentives to encourage companies to convert to the new system and the government is emphasising the flexibility for benefit design as one of the key selling points. No one could claim the idea has been a tremendous success so far, but few expected it to be, for a variety of reasons.

Jayne Bok, senior consultant at Watson Wyatt Korea explains, “The smaller companies have moved first. A couple of large public companies are in the process, which will boost the take-up rate. A government entity, the Korea Minting Company, is now being wooed by the larger pension providers like Samsung. So we may see take-up move ahead faster than anticipated; it may surprise you.” New contributions are expected to surge from 2009 to 2010. Bok says, “People willremain ambivalent through 2008, then you’ll see a flurry of activity in 2009.”

Some $50bn (€36.5bn) of new assets are expected to be transitioned by 2010. By 2020, it is estimated that assets will grow to $300bn. “We’ve passed the $1bn mark, though, in total assets in the new system. If any of the large public companies were to join, that figure will rise very quickly,” says Bok.

The lack of a meaningful tax incentive, investment restrictions and a reluctance from labour unions to change will all hamper progress. DC assets can be invested a little more aggressively than DB. A plan can put 60% put into guaranteed investment certificates and 40% into equities; in reality, it is about 10%. The Government has taken on board criticisms of the 40% cap on equity exposure and there is a suggestion to increase the 40% limit in 2008, but investors are not exactly testing the limits.

While the government believes it has created a suitable environment for companies and employees to adopt the new system, the consensus view is that they haven’t done enough. “The main driver of this should be the government, says Ki-Won Suh, chief investment officer of KDB Asset. “There needs to be some incentive and it is clear that in the long term, companies will take to the pension system, but it will not develop rapidly. And before any of that can happen, there needs to be agreement between labour unions and the companies.” David Kim, the local representative for UK fund manager Forsyth Partners, says: “Even though we have the amended act for DC plans, I believe 80% of employers and employees still prefer their DB plans, so they just want a fixed income product offering 5%.”

Edward Eun, a retirement consultant at Watson Wyatt Korea says, “Most employers are examining the options, whether to remain in the severance system or go into DC. If you segment it, certain industries are moving faster. For example, foreign-based industries are moving in line with their policy in other countries.”So although it seems quiet, there’s a lot of activity. Larger firms are moving forward with their plans under the new system. At Samsung’s various companies (Samsung Life, Samsung Biosciences, Samsung Securities etc) they are already adapting their pension policy. With 5-6,000 employees, that will have a big impact on the market. The biggest of Samsung’s various concerns, the electronics firm, employs 50-60,000 people. They have yet to indicate when they plan to make the transition. A safe bet would be 2009. Others such as Hyundai and Kia have different issues. The labour unions will not accept the change without a challenge. Eun says, “For the employer, tossing pensions into the mix creates a whole new set of problems for them in dealing with the unions. The key here is to make the unions feel there is nothing to be lost from making the transition. So employers are trying to overcome their reluctance by devising good DC plans.”

Watson Wyatt has devised a variety of plans for Korean corporates and not all have gone the DC route. Eun says, “We have a client that is a foreign-based multi-national company. They have chosen to go with a DB plan for Korea. One of the main reason for doing so is that they have a very strong labour union in Korea. In Korea you need to get union consent to adapt the pension plan. The severance payment system is like DB, so it’s no big change for the employee. They will have to make interim payments, so there will be some impact. The firm is currently assessing this and will then put it to the union. It is common however, for unions to demand some extra reward for agreeing to the change, even where the benefit level might be the same. They expect something in exchange for giving their consent. That is way it works. So we will see how this is received.”

Another client is replacing the severence payment scheme (SPS) with a DC plan. The challenge here is that they are running a ‘progressive’ SPS, which means they are providing more than the minimum benefit level. So Watson Wyatt has worked closely with their HR department to assess reasonable salary inflation projections and funding requirements for a DC plan. “Once we have these in place, we examine the employee demographic profile and staff turnover,” says Eun. “We look at the employer’s current pension policy and we also look at competitor companies to see what they have done for SPS benefits and what level they are providing for the DC plan. We know, for example, that very few employees actually retire from the company, so the design we have in place is very fair for those people who move on. We have come up with a plan design that has been approved by the local office and the regional office. We are about to put it forward to the corporate office.

“Once they have assessed and are happy with the financial impact, we will go back to the employees and put the plan to them. It is critical to get the buy-in at the three levels of the group; local, regional and corporate. The local HR people are also crucial to this process. Communication, to me, is very important in Korea, because you have to sell the plan to employees. This involves a good deal of education on what the law is and why the government changed it.”

The company has already selected a pension provider, so they will also be presenting information on the new plan, putting across product choices, describing how to make the right choice and how to access the various funds. Eun says, “We are targeting an 80% consent rate. Legally we only need just over 50% but that level of support would not be good for staff morale.”

Institutional investors dip their toes in the globalasset pool Korea has the second largest institutional investor market in Asia next to Japan, with assets of US$818 billion. Korean institutions such as Samsung Life already invest an estimated 15% of their assets in global markets. But generally Korea has not made a huge impact on the global stage. This is beginning to change, as the National Pension Service, currently the largest Asian public pension fund outside Japan, a 205 trillion KRW (or $220bn) giant, embarks on a plan to expand its investment policy.

As the fund is projected to grow to $450bn by 2012, the NPS hopes to increase the share of global assets to 20% of that total by 2012. The process of allocating was begun in 2002 and the first investments made in 2004. An indication of how conservative many people in Korea are about investment came when the NPS caused consternation when they decided to increase their allocation to Korean equities. Although they were within theirguidelines to do this, it caught some people by surprise. Watson Wyatt’s Jayne Bok explains, “It’s more of a governance issue really. They had only recently received approval to do it, so perhaps there was an element of ‘unseemly haste’ about it.” With a new CIO, Oh Sung Geun, and the backing of stakeholders, they now have agreement to develop their global asset allocation. Oh Sung Geun has made it clear that he has three objectives with respect to the fund management and diversification strategy of the NPS; more investment in risky assets such as stocks and alternatives, more diversified investment overseas and more outsourcing of investment. The NPS has already strengthened its strategic alliance with foreign asset managers. In July 2007, it exchanged MOUs with Credit Suisse Asset Management and Morgan Stanley Investment Management. This year NPS will invest $500m with each for them.

In early March 2007, Sang-Hyon Ryu, senior porfolio manager at the National Pension Service in Korea visited CalPERS and CalSTRS in his role as part of the team working on a strategy to increase the NPF’s allocation to alternative investments. The purpose of the meetings in Sacramento was to gain perspective on the core issues relating to alternative investments with the top pension fund performers in the alternative investments arena. At this point in time, the fund was investing only 1.6% of its portfolio in alternative investments, including real estate and private equity. Ryi says, “NPF is now challenged to extend its investment portfolio with more weight in alternative assets as well as in global markets, pursuing higher risk adjusted returns.”

In August, Watson Wyatt carried out an investment project at the NPS, as part of the initial plan for global allocation. Bok says, “We won the project but this is just the first step, to advise them on the robustness of their process. It’s sort of an audit on the investment processes and the way they are set up.”

Ki-Won Suh, chief investment officer at KDB Asset Management, worked at the NPS during the 1990s until 2003. He comments: “Yes, in a sense, they have been suffering from too much bureaucracy. But to put it in perspective, the recent history of the NPS is very short. They are still learning and gaining confidence in exposing the fund to the swings of risk and return. It is only since the appointment of the current CIO that they have really had a positive approach to active equity investment.”

The NPS is the unfortunate victim of politics, he says: “The Government wants to change the governance structure to their taste. Currently the NPS is controlled by the Ministry of Health and Welfare. The Minister of Finance would also like to have authority over it. So it has become a political football.” Suh worked at the NPS in the era when chief investment officers were routinely fired for poor investment performance, fostering a culture of risk aversion among investment professionals. Suh says, “The CIO didn’t have any control over the personnel deployed within the organisation, added to which the investment division was treated with suspicion by the administrative offices. That kind of negative attitude meant they would always look to pinpoint mistakes and poor results to the Ministry. That is the situation given to the CIO of the NPS.

“If the CIO is given a reasonable risk budget and sensible parameters, he can make more aggressive investments. I have observed public pension funds in the US and Canada. Their investment managers have the same conflicts with their investment committees and consultants. The major difference is their cumulative returns are higher than those of the NPS, because they are allowed to take risk.” It has been suggested that the NPS should become a separate public company, but the matter is not easy to address. The NPS has a constant struggle in getting agreement from all the different interested parties.

“They are gradually enhancing their operations, but they are struggling in the area of asset and liability matching. According to projections, maybe in 2040 the pension fund should be peaking, at more than 1000 trillion Won. After that, the fund will start shrinking fast. People are worried about that and the political parties are trying to make an issue out if it.”

In January 2007, the National Assembly in Korea voted to change the status of NPS from a ‘general investor’ to an ‘institutional’ investor. Yet another regulatory change, this one means the NPS is now free to directly appoint its global custodians. The NPS has recently made use of this new freedom, mandating State Street and BNY Mellon as global custodians and providers of related services such as securities lending. The Bank of New York Mellon has been conducting business in Korea for nearly 20 years. The company has a full branch office in Korea, and its main Asian processing centre is in Singapore.

According to Chong Jin Leow, head of asset servicing in Asia, “Our discussion with the client is in terms of “how we can help you carry out compliance monitoring and to invest according to the guidelines set out by your consultants and investment managers. This involves offering the full range of service in terms of risk reporting. We partner with Wilshire to provide performance and risk measurement services. These are not unsophisticated clients, so they require a top of the range service.”

Chong says, “We see enormous opportunity in Korea. Overall, the amount invested overseas is still quite small. But if Korea buys into offshore investment the way other developed nations have, we will see this segment grow rapidly in a short time frame. The NPS and the more sophisticated and outward looking institutions, such as the Military Mutual, the Teachers Pension Fund and the Cooperative Pension Fund are looking to globalise, but there are few others who are following suit at this point.”

The Military Mutual Aid Association and the Korean Teachers Pension Fund are seen as two of the smaller, more nimble and aggressive pension fund investors in Korea. With combined assets of 14 trillion won, they have been active not only in equities and bonds but also in public infrastructure projects, real estate and M&A deals. For example, in 2001, the MMAA took over Hankook Capital and Daehan Real Estate Investment Trust, giving the fund significant new exposure to alternative assets at a crucial time. More recently, the MMAA entered the private equity space with the establishment of Consus Asset Management, in association with Hanil Cement and Hana Securities.

Macquarie Bank recently created the Korean Road Infrastructure Fund (KRIF) with Sinhan Bank. It is Korea’s first private infrastructure fund, an unlisted fund totaling $290 million. Initial investors include the Government Employees Pension corporation, the Korea Teachers Pension Fund, Military Mutual Fund and Kyobo Life.

Korea’s sovereign wealth fund is the Korean Investment Corporation. The KIC was established by the government of Korea under the KIC Act in July 2005 to manage part of Korea’s foreign exchange reserves and other public funds. At initial stages, KIC is to manage $20bn of which the Bank of Korea and the Ministry of Finance and Economy provided $17bn and $3bn of the funds, respectively. KIC’s mandate is to invest wholly overseas. Indirect only, they are using Russell as the consultant. Roughly half the $20bn has so far been invested. KIC was established with much more of an investment focus (ie total return, not tied to any ALM approach). KIC is not that independent though, it is still a sovereign wealth fund, benchmarking the GIC approach. Other countries are now following suit. Their target is quite modest.

Do they have permission to use alternatives? No, and they don’t have any specialists to deal with that in-house.

Guan Ong, CIO of the KIC has observed that because there are currently few institutions in Korea who have invested abroad, there is a limited pool of experienced global asset managers in country. One of the objectives set by the government

in forming the KIC was to encourage global asset managers to establish their presence in Korea. Ong says, ” KIC will outsource the majority of our assets to be managed by external fund managers and will use this opportunity to work in partnership with our external fund managers to gain exposure and experience for our investment staff in preparation for when KIC starts investing directly. Over the next few years, one of KIC’s biggest challenges will be to develop its own asset management capabilities and to build it right rather than to build it quickly. The capabilities that we will develop will comprise developing the entire chain of operations, from front office to mid and back office.” A mandate from KIC should be seen as “icing on the cake” and not the “cake” itself. In this way, KIC hopes to encourage the development, and to some extent, encourage the sustainability of the industry.

Ong sums up the future for Korea’s pension and investment markets in his vision of ‘a new era in our Asian financial history’: “It reminds me of a common Asian saying that goes like this: In some families, the first generation starts a successful business, the second generation builds on the wealth and the third generation loses it. The first Asian generation had sown the seeds of the Asian economic miracles in the 80s and 90s. Despite the financial crisis of the late 90s, the second Asian generation accumulated a significant amount of foreign reserves.

In the future, will we be judged as the third generation who loses the wealth or the second generation who extended the accumulation of the Asian wealth? I believe there is no choice for us and I mean not just KIC but for all of us. We have been given this opportunity to broaden and deepen the resource pool who will contribute to a sustainable asset management industry.”

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