[Expert Diagnosis] What’s the Solution to the National Pension Crisis?

The management of the fund should be entrusted to the Ministry of Economy and Finance

The National Pension Fund Management Headquarters announced that, as of the end of September this year, the National Pension Fund amounted to KRW 897 trillion and had posted a return of negative (-) 7.06% through September. If the current trend continues, this year’s annual return is expected to turn negative again, following -0.92% in 2018.

The negative return in 2018 was caused by a contraction in global capital markets amid concerns over the U.S.-China trade dispute and a slowdown in the global economy. This year’s negative return reflects the sharp increase in the U.S. policy rate to curb inflation, the continued war between Ukraine and Russia, and the collapse of supply chains caused by COVID-19 lockdowns and the resulting rise in raw material prices. The recent frequency of such external shocks shows that the fund management system must be rebuilt in order to sustain the stable maximization of returns on the National Pension Fund.

The biggest factor behind the negative fund return was the domestic equity segment, whose return was -27.47%. This may be justified by the fact that the KOSPI index fell by -25.47%, but it is hard to avoid the conclusion that the fund is being managed passively, with no rational response to external factors. Moreover, as the largest player in the domestic stock market, the National Pension Fund is imposing serious costs on corporate management by pushing ahead with the Stewardship Code based on ESG (environment, social, and governance).

Until recently, returns on domestic equities had been the highest because of the base effect following the decline in returns in 2018, and thus their contribution to overall returns was inevitably very large. The average annual return for the three years from 2019 to 2021 was 17.6%. If stock investment returns settle at around -25% this year, then the average return for the past three years (2020–2022) will fall to 1.98%.

That would offset almost all of the record-breaking returns accumulated over the previous two years. If the National Pension Fund’s return this year is -7.06%, then the average annual return over the past three years will fall from 10.6% to 4.14%. This underscores how important stable returns are in long-term investment. Returns on overseas equities and domestic bonds were -9.52% and -7.53%, respectively. Overseas bonds and alternative investments posted returns of 6.01% and 16.24%, respectively. The negative return on domestic bonds also resulted from Korea’s sharp interest rate hikes, which drove down bond prices.

The social opportunity cost of the National Pension Fund must be considered

The nature of the National Pension Fund is highly multifaceted, beyond being merely a reserve for pension payments. First, the National Pension Fund is a form of compulsory saving collected from the public, now approaching KRW 900 trillion, and it is expected to grow to KRW 1,778 trillion by 2041.

If this is discounted to present value at 2018 prices using the annual inflation rate of 2% applied in the 4th National Pension Financial Recalculation, it amounts to KRW 1,078 trillion (or KRW 1,167 trillion in 2022 terms). That would make it a gigantic fund equivalent to about 44.1% of the KRW 2,649 trillion market capitalization of listed companies as of the end of 2021. This fund is not a net reserve of surplus funds; it is destined to be spent down over a period of more than 10 years starting in the 2040s to pay pension benefits. Its stable management must therefore not be neglected.

Moreover, if pension contributions are raised and the pension eligibility age is increased in order to stabilize the finances of the National Pension system, the size of the fund will increase much further. The National Pension Expert Forum (2022.12.10.), recently operated by the government, argued that in the long run the contribution rate should be raised from the current 9% to 15%, and the pension eligibility age should be increased to 67.

According to the results of the 4th National Pension Financial Recalculation, the National Pension Fund will peak at KRW 1,778 trillion in 2042, but under reform scenarios it is estimated to increase sharply to between KRW 2,773 trillion (Scenario 1) and KRW 3,390 trillion (Scenario 2) in the 2050s. In other words, if reforms for the future financial stabilization of the National Pension are implemented, the peak size of the fund will increase by roughly 60% to 90% over current assumptions. This means the National Pension Fund will become a mega-fund unlike anything seen in the history of any country in the world. Unless the National Pension Fund is proactively reformed in line with the future economic environment, management risk could lead to a serious socioeconomic crisis.

The National Pension Fund is operated as a single fund under a single decision-making body and a single governance structure, namely the National Pension Fund Management Headquarters. As its size grows, the possibility that governance risk in fund management could increase explosively must not be overlooked. This means the negative impact of the National Pension Fund on Korea’s economy, public finances, and capital markets could increase significantly.

The National Pension reform plan currently being considered by the government will inevitably raise contribution rates, meaning individuals will have to reduce their personal savings by more during their working years. At the same time, expectations of guaranteed benefits from the National Pension may rise, increasing dependence on it in old age. This runs counter to the global trend of emphasizing the importance of private pensions in old-age security systems.

Given that the National Pension Fund has already grown to a size that occupies a dominant position in the capital market, it is now time to examine the opportunity cost it imposes on our society.

First, for individuals, this is money that should have been used during their working years for housing, medical expenses, education, and the like, but the government has taken it in advance as old-age funds through the National Pension system as a paternalistic policy. As a result, individuals face liquidity shortages in financing these costs. They then borrow urgently needed funds for such purposes in the capital market at high interest rates. The National Pension Fund is imposing a very high opportunity cost on individuals.

Second, businesses also suffer from a shortage of funds they can borrow because money that should have circulated in the private capital market through individuals’ savings is instead being managed by the government as the National Pension Fund. The National Pension Fund, formed by government coercion, does not circulate evenly through the private capital market. In particular, although small and medium-sized enterprises pay 4.5% in National Pension contributions, nearly all of this money is invested in the listed shares of a small number of large corporations. The purchase of government and public bonds means the National Pension is being used to finance government fiscal deficits. Overseas investment also results in domestic funds flowing abroad, reducing the sources of financing for domestic firms. Considering the opportunity costs directly borne by individuals and businesses at home, one must conclude that the benchmark return on overseas investment should be high enough to fully compensate for these costs.

Third, the National Pension Fund’s stock investment is increasing volatility in the capital market and causing market instability. A recent example is that, because of high stock market returns, the fund had to sell stocks to maintain its strategic asset allocation ratio. As a result, related stock prices fell sharply. Conversely, when stock prices have declined on an ongoing basis, the National Pension Fund has stepped in to buy stocks to support the market, thereby distorting it.

Because the National Pension Fund seeks to maximize returns based on its influence as a large-scale pool of capital, it has no choice but to sell stocks preemptively when prices fall, and also to sell stocks to realize gains when prices rise. As a result, individual investors participating in stock trading cannot avoid being affected by the National Pension Fund’s stock transactions whether prices are falling or rising.

Until now, the National Pension Fund has supported the capital market through net purchases. These roles have distorted the capital market by preventing stock prices from properly reflecting corporate value. In addition, although ESG does not reflect market value, applying the Stewardship Code imposes additional burdens on firms and further distorts stock prices.

Fourth, the National Pension Fund is a reserve for paying National Pension benefits, but because of the structural deficit of the National Pension system, the fund is projected to reach balance in 2041 and be depleted in 2057. Therefore, during the contraction phase of the fund after 2041, capital will flow out of the capital market continuously and on a large scale. Along with the capital market, our economy could fall into a severe state of panic.

The distortions in the capital market caused by the National Pension Fund lead to distortions in public finance and the economy as a whole. Population aging, already a major social issue, constrains economic growth, meaning there are inevitable limits to improving returns through the National Pension Fund’s capital market operations. Moreover, with the total fertility rate remaining in the 0.7 range and the population declining, any failure in managing the National Pension Fund would impose a burden that the next generation could never bear. Therefore, the National Pension Fund’s stock market investment must minimize these problems, and innovation in its governance structure for that purpose is unavoidable.

The purposes of the National Pension system and the National Pension Fund are separate

The purposes of the National Pension system and the National Pension Fund are separate. The National Pension system exists to provide old-age security. The National Pension Fund, however, has the function of managing and operating the fund within the National Pension system, and its purpose is to maximize returns. It serves the financial role of funding National Pension expenditures. Given the special nature of the pension fund as the public’s savings, priority should be given to establishing a legal governance structure that allows it to be managed transparently and professionally.

There is no master key that can solve all of the above problems at once. The scale of the National Pension Fund has already grown explosively, and together with the National Pension system, its effects on our society are intertwined in excessively complex ways. Simply pursuing returns can never resolve the other stakeholder issues surrounding the National Pension Fund. Therefore, we should seek alternatives that steadily minimize the problems mentioned above while guiding long-term returns in a stable manner.

First, a separate National Pension Fund Act under the jurisdiction of the Ministry of Economy and Finance should be enacted for the stable management of the National Pension Fund. The operation of the National Pension system should remain with the Ministry of Health and Welfare, while responsibility for managing the National Pension Fund should be separated and assigned to the Ministry of Economy and Finance, which oversees macroeconomic management. Within that law, the National Pension Fund Management Headquarters should be separated from the National Pension Service and converted into a National Pension Fund Corporation.

The National Pension Fund consists of money entrusted by the public, who give up their own financial needs during their working years in order to save for old age. Therefore, responsibility for its management must be clearly defined. Under the responsibility of the Ministry of Economy and Finance, which has expertise in capital market policy, macroeconomic information, and abundant human resources and networks, the fund should contribute to national economic stability while maximizing returns. There are limits to having the Ministry of Health and Welfare, whose main work is solving the public’s poverty problems through taxes, bear responsibility for fund management as it does now.

Second, the National Pension Fund should not continue to be operated as a single fund as it is now, but should instead be divided by size into separate funds with independent governance structures that compete with one another. The risks that may arise from operating a single fund that will surge beyond KRW 1,700 trillion in the future have unclear lines of responsibility. Competition among individual funds will lead to higher returns. Funds with low returns or poor efficiency should be dissolved first, thereby maximizing fund returns and improving predictability in the capital market. This would also serve as a means of resolving the turmoil in the capital market that will occur during the period when the National Pension Fund begins to decline from the 2040s through the 2050s. Assuming future pension reform inevitably requires greater fund accumulation, divided management of the fund becomes even more urgent.

Third, an expert-centered National Pension Fund Committee should be established. The National Pension Fund has been accumulated under multiple governments. However, the fund can always face the risk of depletion because of the misguided policy of just one government. Therefore, the directors of the National Pension Fund Corporation should be appointed entirely from the private sector, completely excluding government personnel, and it should be operated on the basis of unanimous agreement. They should also be required to appear at National Assembly hearings.

Fourth, the regional relocation of the National Pension Fund Management Headquarters is also urgent. The management of a fund that belongs among the world’s three largest sovereign funds inevitably requires access to the information networks of global financial markets. The location problem of the Fund Management Headquarters cannot be solved simply by providing ultra-high-speed internet infrastructure. It must be placed where diverse international information and human exchanges are possible both in real time and face-to-face, allowing rapid decisions to be made. The financial center of Seoul, where all socioeconomic infrastructure is concentrated, offers the environment in which investment professionals can fully demonstrate their capabilities and international human resources can be absorbed. Furthermore, in order to improve returns in global financial markets, information networks with global financial centers such as London and New York should also be activated so as to address time-zone issues.

Finally, the National Pension Fund should not apply the Stewardship Code based on ESG. ESG is meant to provide investment information to private investors. Individual companies grow in different industries and under different circumstances. They therefore inevitably face different ESG issues.

Although environment, social issues, and governance cannot be reduced to a single combination, evaluating all firms externally by a single indicator only highlights a distorted image of companies. The Stewardship Code likewise is a set of standards that investment institutions declare in the name of responsible investment toward investors.

The moment the government’s National Pension Fund applies ESG or the Stewardship Code, they cease to be private investment criteria and become government investment criteria, producing the result of steering private companies toward becoming public enterprises.

Therefore, for market-neutral investment in the private sector, rather than directly interfering with firms, the Wall Street rule should be used, employing means such as selling shares in problematic companies or withdrawing investment. Moreover, when the Stewardship Code can only be applied in a limited way to foreign companies, forcing it only on domestic firms is reverse discrimination against Korean companies and could lead to a decline in national competitiveness.

Wonsik Kim, Emeritus Professor at Konkuk University and Visiting Professor at Georgia State University

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Original title: [전문가 진단] 위기의 국민연금 해법은?

Author: Won-sik Kim

Date: 2022-12-23

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&idx=25228