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Early days for DC Korean-style

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On 1 December 2005, the Employee Retirement Benefits Security Act (ERBSA) came into force in South Korea with the potential to change the corporate pension market radically, aligning it more closely with retirement systems used in other major Asian economies.

Prior to the introduction of ERBSA, all companies in Korea provided retirement benefits in line with mandatory defined benefit (DB) rules. These mandate all companies to provide employees with at least one month of final pay for each year of service. 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 of final pay for each year of service.

There are no real funding rules for these pre-ERBSA plans. Companies do not have to set up external funds to support the pension plan but they can and there are corporate tax incentives for companies who do so. Any assets that are set up have to be held in trust as "retirement insurance" contracts with a registered service provider. There are no requirements to carry out "funding valuations" of these pre ERBSA plans and the local accounting treatment is relatively simplistic.

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 defined contribution (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 assets must still be held in trust with a provider and there are new criteria that providers must meet before they can register. Regular funding valuations of DB plans must also be carried out.

The key aim of ERBSA is for companies to review their current retirement plan and convert it to a new "ERBSA approved" retirement plan. There is a lot within the legislation for companies to get to grips with and the government is targeting the end of 2010 for all companies to have converted to a new plan. 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.

 

What's the impact?

We are over a year into the ERBSA era and it's a convenient time to look back at what has changed. The first thing to note is that there hasn't been a ‘big bang'. The government was hoping (and many analysts were predicting) that there were would be a lot of corporate activity in this area over the past year. This hasn't really materialised and only a small minority - around 6,000 companies - had actually registered a new retirement plan in the first year of ERBSA (see Figure 1).

Many companies have been adopting a "wait and see" approach. This is understandable; the tax incentives on offer are relatively small and 2010 is a long way off. However, the past few months have shown a significant upturn in corporate activity. The government has started to apply significant pressure to quasi-government organisations (the railways, the waterways, etc) to set up new pension plans and many were in the process of getting the implementation finalised at the end of 2006.

Alongside this, foreign-owned multinational companies are coming under pressure from regional management to take action and modernise their pension plans in Korea. Most major economies in Asia have been through similar legislation in recent years and regional management sees this as an opportunity to go through the same modernisation in Korea. Again, the past few months have seen a flurry of activity with a lot of multinationals now taking advice to implement a plan that is consistent with what they do in other Asian countries (see Figure 2).

 

DC Korean-style

For most foreign-owned multinationals the modernisation of the retirement plan will be based around a move to a DC plan. There are some basic features that are likely to be common to all plans.

Firstly, 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. There is the option to convert the lump sum into an annuity but the current market terms are uncompetitive.

There are no real tax incentives for employees to contribute and so the contributions are likely to be solely from the employer.

Beyond these basic features, the plans are likely to look quite different. We are already seeing plans being registered with contributions linked to service or employee job grade. We are also seeing DC plans being introduced for new employees whilst existing employees are being allowed to keep their current DB. Interestingly, though, we are not yet seeing contribution rates linked to age - something that has been a common feature of DC plans in Europe and the US.

The other key area for DC plan design is over the investment options to provide to employees. The government is concerned about individuals taking on too much investment risk and ERBSA has specific investment parameters; 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.

From the available data, many employees are choosing to invest their money very cautiously. Cash funds are far and away the most popular in the current DC market and are returning between 4-5% pa to individual funds.

If DC is likely to be the fashion for foreign-owned companies then the opposite is likely to be true for many domestic companies. Many local companies have strong unions that are sceptical about the concept of DC plans and will probably try and block any changes to the current DB retirement system. Whether this will be the case in the longer term is unclear but, for now at least, very few local companies are moving to a DC plan and instead are looking to maintain something similar to the status quo.

Although we're only in the infancy of the ERBSA era a clear trend of diversity is emerging. Foreign-owned companies are moving towards a DC approach that is consistent with the rest of Asia whilst local companies are looking to slightly adjust the current DB system. This trend is likely to continue as the market matures and convergence to a common system seems some way off - but then the whole point of ERBSA is flexibility.

 

Service providers - a free lunch?

Another key part of the ERBSA legislation covers the administration and investment service providers. ERBSA specifies strict criteria for companies to meet if they wish to register as service providers. There are 45 providers registered and they are all major financial institutions. All but one of the companies has registered to provide both of the key services of administration and investment.

The providers intend to make their profits via administration and investment charges. The charging structures vary and, as expected, the big life insurance companies have taken an early lead in this market. They already dominate the pre ERBSA market and are using their strong brand and existing relationships to gain a foothold in this new market (see Figure 3).

The provider market is highly competitive with many companies using aggressive marketing tactics and the offer of "free services" to help win the investment service contracts. One of these free services has been "consultancy advice", with many providers offering to design and implement the new retirement plan in exchange for the investment service contract.

With pension design being a relatively new concept in Korea it is not clear that all of the service providers have the necessary expertise and experience to deliver these services. There is also the concern that their vested interest in securing the asset contract will influence their ‘advice' over the design of the new plan. For instance, would the existing investment service provider recommend a move to a DC plan if it could lead to questions about the most appropriate DC
provider?

In this immature market, it is important to exercise caution when confronted by the aggressive marketing tactics and free services on offer from the providers. There is no such thing as a free lunch and it remains to be seen whether these providers are offering long-term value.

Carl Redondo is senior international consultant with Hewitt in Seoul

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