Extending the C overage of the F ormal S ector S cheme in Korea

1. Extending the Coverage of the Formal Sector Schemein Korea Wonshik Kim wonshik@kku,ac.kr December 1, 2006

2. Contents • Introduction • The System of National Pension in Korea • What Korea Does for the Future of National Pension • Policy Directions for Workplace Based Pension V. Conclusion: Experiences of Korea National Pension in Korea

3. I. Introduction

4. I. Introduction Introduction • Accelerated Population Aging in Korea • Very low fertility rate: 1.15% in 2004 • Higher longevity: 74.3 for men, 81.2 for women • Strong Demand for Safety net: Major environmental changes in social insurances since the 1960s • Workers’ compensation since 1963 • Health insurance since 1980 • National pension since 1988 • Employment Insurance since 1994 • Now, the above four social insurances cover all population • Long-term care are expected to be launched in 2007.

5. I. Introduction Introduction-continued • Step-by-Step expansion of National Pension Coverage • Implementation of National Pension to workplaces with more than 10 full-time employees in 1988 • Expansion of the coverage to workplaces with more than 5 full-time employees in 1992 • Expansion of the coverage to the farmers, fishermen and all residences in rural area in 1995 • Expansion of the coverage to urban self-employed in 1999 • Workplace-based scheme: full time workers in a firm with more than or equal to 5 full-time employees • Individual-based scheme: the remaining workers of the firms with less than 5 and more than one full-time employee and their employers • Rural insurants: farmers and fishermen • Urban insurants

6. I. Introduction Introduction-continued • Lower participation leads insufficient benefits for retirement and more government assistances to fill up the pension gap (= minimum living cost of aged – pension received) • Sustainability: Trade-off in policy goals under incomplete information • High enforcement and underreport of income • True income revelation and voluntary participation • Higher enforcement lead distortions of informal labor market behavior • Avoidance of paying contributions of social insurances, overall • The financial instability of National Pension • The break-even of cash follow is expected in 2036 • 150 billion Dollars is accumulated as a pension fund. • 800 billion Dollars as a present value is expected in 2036.

7. I. Introduction Introduction-continued • The depletion of pension fund is expected in 2047 • Low contribution high benefit structure • ROR on pension fund was 12-3% in 1990s. • Average lifetime of Korean was about 67 years in the late 1980s. • i.e. financial market risk and longevity risk would contribute the future deficit of national pension.

8. II. The System of National Pension in Korea

9. II. The System of National Pension in Korea Basics for Evaluation • High compliance of workplace based scheme and Low compliance of individual based scheme until 2003 • High administration cost of individual based scheme for small sized workplaces (formal sector) • Unclear income records for their employees • Informal labor contracts of formal sector • Frequent move of their offices • Frequent in and out of business • Less than five full-time employee workplaces are excluded • Exclusion of irregular employees in the formal sector for various fringe benefits, such as safety nets. • Unintended discrimination against irregular employees • Poor irregular employees have no interest on national pension because of their burden on contributions

10. II. The System of National Pension in Korea Basics for Evaluation-continued • Large share of informal sector in Korean labor market • 50% of employees are irregular workers • 40% of labor force on their own business • Strict business accounting is not required for small firms. • Contribution deals between employees and employers are possible. • Outside auditing system is not enforced for midium and small firms. • Two different aspects in extending formal sector scheme’s coverage • Irregular employees of medium and large workplaces • Expandable by various enforcement measures • Employees of small workplaces • Expandable by incentives

11. II. The System of National Pension in Korea Basics for Evaluation-continued • Policy Alternatives – for the poor – causing confusion: Participate? Contribute? • Aged Allowance for the aged over 65 • Basic Living Cost Guarantee Act (2000) • Basic pension financed by government revenue (discussion on reforming National Pension in progress by politicians) • It is an assistance, not pension. • EITC (discussion in progress by government) • Corporate pension transformed from mandatory severance Pay in 2005 • i.e. negative signals in decision on participation of National Pension for poor working groups

12. II. The System of National Pension in Korea Major Contents of Workplace Based Scheme • Coverage • All employers and employees at (formal / informal) workplaces with more than one full-time employee • Those not included in full-time workers: • Daily workers / workers with a contract that lasts less than a month • Workers who are not employed for continuous purposes, such as part time workers with less than 80 hours per month. • Under18 years old and more than 60 years old

13. II. The System of National Pension in Korea Major Contents of Workplace Based Scheme-continued • Contribution is equally shared between employers and employees: 4.5% each • No income record for small workplaces • Very poor accounting system, even in some professional offices such as lawyer and physician’s office • Negotiation on contribution between them are liable.

14. II. The System of National Pension in Korea Major Contents of Individual Based Scheme-continued • Coverage: those who are neither in workplace based scheme nor voluntary insured, for example: • the self-insured • Irregular (temporary and daily) workers and part-time workers in a workplace with more than one full-time employees • Non-income earners • Contribution of 9% of their income is fully burdened by the individual based insurants • Voluntary report system of income for contribution

15. II. The System of National Pension in Korea The Benefit Schedule for both • Pension Benefit= 1.8* (A+B) * (1+0.05N) • A: The average monthly income of the all workers • B: The average monthly income of the insured workers • N: The number of insured years in excess of 20 years • A is the redistributive component • B is the proportional component to individual worker’s income

16. II. The System of National Pension in Korea <Table> The Trends of Insurants by Scheme

17. II. The System of National Pension in Korea The Three Steps for Expansion from 2003 • Three steps to expand the coverage of the workplace based pension from 2003 • First, irregular employees of workplaces, with more than one employee, that were corporations and professional offices in 2003 • Second, workplaces applied by national health insurance and employment insurance, that did not belong to the first step in 2004 • National health insurance and employment insurance have higher participation. • Their risks (Health risk and unemployment risk) are more urgent than that of pension • Third, the rest of the workplaces in 2006

18. II. The System of National Pension in Korea The Three Steps for Expansion from 2003-continued • 57.8% of the newly insured were exempt from contribution in the first step of workplace based scheme expansion • The reasons for exemptions from expanding of workplace coverage: • Close-out or out of business (31%) • Unknown address (28%) • No employees (22%) • The average reported income of the newly insured was lower than average income of the existing workplace based insurants by ~15%

19. II. The System of National Pension in Korea The Three Steps for Expansion from 2003-continued • Why did Korean government expand the coverage of the workplace based scheme excessively? • Lower management cost was expected • Employers (not employees) obliged to pay contribution • Half the burden of the insurants compared to that of individual based scheme • Deep worries for the rapidly aging population • Recent social demand for policies favoring irregular workers and their organized strong voices

20. II. The System of National Pension in Korea The Three Steps for Expansion from 2003-continued • What is the problem of the excessive expansion of Workplace based scheme? • Frequent mobility in workplaces and employees for the targeted groups • Difficulties in tracing insurants • Avoidance of employers to pay contribution of their employees • Changes in employees' actual status • Changes in employees’ status into fictitious one • Pay with cash without payroll records • Ignorance of their duties to pay contribution

21. II. The System of National Pension in Korea The Three Steps for Expansion from 2003-continued • Lower pension benefits of existing workplace based insurants - lowering average income of all insured in benefit formula • complaints of the existing workplace insurants

22. II. The System of National Pension in Korea <Table> The Result of the First Step Workplace Expansion (Dec. 2003)

23. II. The System of National Pension in Korea <Table> The Average Reported Income of the First Step Workplace Expansion unit: thousand Won • Why are they lower their reported income? • No incentive to save money in national pension for retirement: out of their pocket • No measure to monitor the reported income • The lower reported income, the higher rate of return on the contribution

24. II. The System of National Pension in Korea <Table> The Mobility of the Insured to Workplace Based Scheme Unit: person

25. II. The System of National Pension in Korea <Table> The Difference of the Reported Income under Different SchemesUnit: Thousand Won

26. II. The System of National Pension in Korea <Table> The Result of the Third Step Workplace Expansion (June 2006) <New Insurants> <Average reported Income of New Insurants> Unit: thousand Won

27. III. What Does Korea Do for the Future of National Pension?

28. III. What does do Korea for the future What Does Korea Do for the Future of National Pension? • Basic Pension: Suggested by the minority party • Guarantee basic cost of retirement: 20% replacement ratio is demanded by the largest minority party • Not contributory and Tax financed: government burden too heavy • It can be a policy for the low income workplace employees and exempted participants of individual based insurance

29. III. What does do Korea for the future What Does Korea Do for the Future of National Pension? - continued • Old aged allowance • Over 65 aged income tested allowance • Government is expected to increase beneficiaries to about 60% of the aged over 65 – as a complimentary of pension reform • Individual based insurants can expect to be benefited • Earned income tax credit • Expected to be introduced in 2008 • Maximum amount to be 800 thousand Won (about 800 U.S. dollars). • Income records are available for self-employed or irregular workers

30. III. What does do Korea for the future What Does Korea Do for the Future of National Pension? - continued • Integration of the collections of the four social insurances and the Collection Agency under IRA • Pro • It may raise efficiency in the process of collection / decrease administration cost • More income record and insurants’ information are available • Reduce labor force required in social insurance agencies

31. III. What does do Korea for the future What Does Korea Do for the Future of National Pension? - continued • Con • Other agencies without the certainty of efficiency enhancement • The income records of self-employed and irregular workers do not exist in the real world • Separation of the revenue and expenditure does not lead to efficiency in managing risk: check and balance is not possible within a system • The borderline of the functions between IRA and Collection Agency is not clear: competition between growth and redistribution in government financing

32. IV. Policy Directions for Workplace Based Pension Scheme

33. IV. Policy Directions for Workplace Based Scheme Policy Directions for Workplace Based Pension • Mandatory expansion should be reconsidered • Low compliance ratio • Hard to monitor reported income • Other safety-nets are not sufficient • Housing • Health care • Workplace safety • Long-term care • i.e. the priority of retirement is still low. • Strong enforcement raises administration cost • Job mobility eventually equalizes their contributions in the long run.

34. IV. Policy Directions for Workplace Based Scheme Policy Directions for Workplace Based Pension - continued • Flat rate contribution can be considered for small workplaces • Actual income record is not available • Unequal treatment on income sources between workplace based and individual based scheme • Workplace insurants: contribution on labor income • Individual insurants/self-employed: contribution on labor income and their capital income from their workplace • Keep pace of expansion with the development of labor market • High share of informal sector in the labor market

35. IV. Policy Directions for Workplace Based Scheme Policy Directions for Workplace Based Pension - continued • To give credit for the firms which allow qualification of their irregular employees for workplace based pension. • In accounting, lump-sum labor cost for irregular workers with ID can be induced to be reported. • Fixed contribution for the reported irregular workers. • To adopt employee friendly policies: mini loans, micro financing, etc

36. IV. Policy Directions for Workplace Based Scheme Policy Directions for Workplace Based Pension - continued • To separate budgeting system between workplace based and Individual based schemes or financing methods of “A” based benefit and “B” based benefit • Now • Cross income subsidy between the two. • The existing low income workers suffer from loss of benefit • The moral hazard of individual based insurants • Government finances the deficit of one of the schemes, for example, individual based scheme, “A” based beneift, or flat contribution scheme. • Income test based government subsidy for individual based insurants • Reorganization of labor market in the long-run

37. IV. Policy Directions for Workplace Based Scheme Policy Directions for Workplace Based Pension - continued • What should we do with National Pension in case of Korean Unification? • Flat contribution pension scheme should be designed before Unification.

38. V. Conclusions: Experiences of Korea

39. V. Conclusion: Experiences of Korea Conclusions: Experiences of Korea • Misunderstandings on the National Pension • A policy for the poor? • Excessively income-redistributive benefit schedule • A first generation’s problem should be granted? • Excessive requests from the aged • Increasing aged allowance • Expansion of the aged allowance coverage • Should the giant national pension fund be separated from the insurants? • No actual relations between national pension fund and insurants

40. V. Conclusion: Experiences of Korea Conclusions: Experiences of Korea-continued • All monthly payments system for the aged is pension? • Pension should be based on contribution.

41. V. Conclusion: Experiences of Korea Conclusions: Experiences of Korea-continued • National Pension is a financial product to be sold • Incentives for the poor employees of small workplaces • Income redistribution • Flexible contribution • Credits for the workplaces qualifying their employees to the workplace base scheme • Conceptual separation of contribution and tax • Otherwise, aged allowance financed by tax

42. V. Conclusion: Experiences of Korea Conclusions: Experiences of Korea-continued • Income data system should be linked with those of other social insurances and matched with IRA income record • The payroll of the workplace workers should be kept in detail. • Incentives for employers to participate in qualifying their employees • Administration of the workplace based pension should be more flexible in complying the system: contribution is not a tax. • Flat rate contribution may be allowed.

43. V. Conclusion: Experiences of Korea Conclusions: Experiences of Korea - continued • Optimal expansion of informal sector scheme exists! • Administration cost • Regulations as an incentive for employers

44. Thank you! National Pension in Korea