Already a hot topic thanks to ongoing discussions concerning the National Pension Scheme, the South Korean parliament recently diverted further attention towards retirement issues following the introduction of much-anticipated corporate pension reforms.

Until recently, pension provision in Korea has been fairly low key. Two primary sources currently exist to provide retirement benefits, but neither system is ideal. The situation changed in 2003 when, following extensive negotiations with unions and employers, the Government submitted a draft bill proposing a new regulatory framework for retirement schemes. The Employee Retirement Security Act was passed by the National Assembly in late 2004 and will become effective on 1 December 2005, but how does this differ from the present system and what does it mean for employers and employees?

Existing Retirement Schemes

State Support

Korea introduced the “Pay-As-You-Go” National Pension Scheme in 1988, under which taxes paid by current workers are used to fund payments to current pensioners. However, rising life expectancy and falling birth rates mean that too many pensioners are now reliant on too few workers. Projections by the Korea Development Institute show that without significant reform, taxes collected will be insufficient to finance the promised payments. Proposals have already been outlined which would reduce payments and raise contributions into the system—although these are still subject to formal approval—but many people still lack confidence in the National Pension Scheme.

The Severance Pay System

Since 1953, all companies in Korea with five or more employees must provide a lump sum severance payment roughly equal to at least one month’s pay for each year of service. However, the current system has several undesirable features:

• Many employees in Korea work for small companies, which are often exempt from the payment of severance pay. Such employees build up no provision for retirement.
• The severance payment is a multiple of the employee’s pay received in the final period of employment, which may lead to unpredictable employer costs if salary growth is not contained.
• Payment can be taken as a lump sum at the time of leaving employment, and accrued severance can even be paid while still in employment—a practice known as “interim settlement. Such flexibility fails to encourage adequate security of income once the employee has finally stopped working.
• Companies are not required to set aside external assets to meet these eventual payments, which can cause future cashflow strains. In the extreme case where an employer becomes insolvent, employees can face the double problem of losing their job and receiving no severance pay.

The Employee Retirement Security Act

The Employee Retirement Security Act (ERSA) provides a solution to many of these issues and introduces several new aspects of retirement provision that will be of interest to both employers and employees.

Existing severance pay provision is still allowed under the Act; however, the ability to use “Retirement Insurance” deposits to offset the severance payment will be eliminated by December 31, 2010. Employers who currently utilize Retirement Insurance may see their overall obligations increase after this date.

Defined Benefit Retirement Plans

Defined Benefit Retirement Plans (DB plans) will become an alternative to providing severance pay, although they share similar characteristics in that the payment must still be equivalent to at least one month of “final pay” for each year of service. Stricter guidelines apply to the funding and disclosure of information that employers must provide, and restrictions apply on withdrawing funds before age 60.

Defined Contribution Retirement Plans

Defined Contribution Retirement Plans (DC plans) offer a significantly different alternative to severance pay. These work like a savings plan, so that regular contributions are added to an account by the employer and invested in accordance with specific instructions. Employers must contribute at least 8.3 percent of pay into these accounts and additional voluntary employee contributions allowable, with the eventual payment being linked to the value of the account. Guidelines covering investment choices, disclosure of information and withdrawal of funds before age 60 apply.

Individual Retirement Accounts

Individual Retirement Accounts (IRAs) can be established as an alternative by employers with a workforce lower than 10 employees, or by individuals wishing to secure additional retirement benefits.

Impact on Cost for Employers

The Government aims to encourage establishment of the new alternatives through a range of incentives to employers. These details—in addition to many others—are not yet available but will be announced via Presidential Decree in the near future.

Theoretically, the cost impact to employers of operating a new DB or DC plan compared to the existing severance pay scheme should be quite similar. However, DC plans allow employers greater cost certainty since the obligation is limited to the contributions paid into employee accounts. The risk of investment returns being different to those expected is transferred to employees under this system.

The new DB and DC plans require assets to be set aside in advance, which may lower an employer’s immediate cash reserves. Such “pre-funding” will appeal to employers who wish to mitigate the impact of cashflow requests at a later date.

The new proposals affect not only future retirement provision, but also existing severance pay accrued before December 1, 2005. Employers will need to decide to how to deal with these existing obligations, with the decision having a potentially significant impact on the balance sheet and income statement. Options to transfer severance pay to one of the new arrangements appear possible, but have not yet been clarified.

The Next Step

Jim Humphrey, Head of Hewitt’s Retirement and Financial Management practice says, “We welcome these reforms as a significant first step towards greater security for employees in their retirement. The extent to which employers take advantage of these new schemes depends upon many factors, such as the level of tax incentives offered by the Government and the ability of service providers to offer attractive investment and administrative solutions.”

Humphrey advises that whether you’re a CEO, Finance Director or HR Manager, it’s worth keeping a watchful eye over these reforms and how they develop. Consent from the “Employee Representative” is required for all decisions, even for employers who choose to take no action. Fines and imprisonment await those who fail to carry out their responsibilities with the necessary care and attention.

Employers may wish to review overall compensation and benefit provision before making a decision about retirement schemes. Like all other items of remuneration, retirement provision should align with an employer’s HR philosophies and general business objectives. Valuable insight can also be gained from analyzing the competitiveness of your current severance pay provision and the value of accrued severance obligations.

The concept of individuals taking investment responsibility for their retirement provision via DC plans is quite new to Korea, and DB plans will also see a wider range of investment options for employers. Investment education is critical if these new alternatives are to be understood, and effective communication techniques will increase the chances of employees accepting and buying into any changes proposed.

(This article first appeared in Hewitt Quarterly Asia Pacific magazine, May 2005)