KDI Korea Development Institute

Summary

Research Monograph KOR Research on Structural Reforms to Enhance Sustainability of the Public Pension System

This study aims to explore structural reform measures for South Korea’s national pension scheme that can ensure both fiscal sustainability and intergenerational equity. Additionally, it seeks to redefine the basic pension system to guarantee an adequate level of retirement income. To achieve these objectives, the paper integrates fiscal projections, based on a new fiscal forecasting model, with analysis from an overlapping generations (OLG) model. Furthermore, it addresses legal issues related to pension reform and examines cases from major countries where social consensus was achieved during the reform process. The paper also discusses the introduction of the Guarantee Pension and various issues facing public pension systems in Korea.

Chapter 2. Reform Measures and Projections for the National Pension System

This chapter examines reform measures for the national pension system and analyzes their fiscal implications. Since its introduction in 1988, the national pension has undergone several reforms, adjusting both the contribution rate and the income replacement rate. However, earlier reforms seem inadequate to secure long-term fiscal sustainability. Therefore, this research has developed a projection model based on models from the National Pension Research Institute and the National Assembly Budget Office to estimate the current financial situation.

The fiscal projection model estimates the revenues and expenditures of the national pension using demographic forecasts, macroeconomic outlooks, and policy variables. According to the projections, its surplus, which stood at 72.1 trillion KRW in 2023, is expected to turn into a deficit by 2040 and further expand to a deficit of 1,005.2 trillion KRW by 2100. Consequently, the pension fund, which was 1,015.8 trillion KRW in 2023, is projected to reach a peak of 1,972.0 trillion KRW in 2039, after which it will gradually decrease to depletion by 2054.

To enhance the sustainability of the national pension, a scenario analysis is conducted, which suggest that raising the contribution rate from 9% to 12% would deplete the fund by 2060. An increase to 15% would extend solvency to 2068, while a rate of 18% would last until 2079. These findings indicate that even with a substantial and challenging increase in contribution rates, the current defined benefit (DB) scheme―which guarantees a benefit ratio over 2 regardless of contributions―would makes it difficult to sustain the fund throughout the projection period. This highlights the challenge of securing intergenerational equity and maintaining the pension fund's solvency solely through contribution rate increases under the current pension structure, which may face resistance from younger generations.

In response, this research proposes a structural reform of the national pension scheme by introducing a reformed defined contribution (DC) system called the "New Pension," while referring to the pre-reform DB system as the "Old Pension." The shortfall in benefits under the Old Pension would be covered by the government budget, allowing all generations to receive at least their principal contributions back (expected benefit ratio of 1).

The proposed DC New Pension would operate as a Cohort Collective Defined Contribution pension system, where individuals within their cohort participate in an insurance scheme to receive a pension benefit amount until death. To this end, a model has been developed to project revenues, expenditures, balance, and reserves under this system. The results indicate that under the cohort-based DC scheme, the pension fund would not be depleted, even with declining birth rates or extended projection periods, as benefits are paid only from the accumulated contributions and investment returns.

However, since the Old Pension inevitably leads to a fiscal deficit, the study also calculates the scale of this deficit. While various methods exist to measure the shortfall of public pensions, this study aligns with the logic of the Old Pension by calculating the benefits corresponding only to contributions made by current beneficiaries and active contributors (closed group method without future accruals). The financial deficit for contributions made up to 2023 is estimated at 609 trillion KRW (in 2023 present value), but if contributions continue until 2028, this deficit is projected to rise by an additional 260 trillion KRW, bringing the total shortall to 869 trillion KRW. This emphasizes the need to implement pension reforms as early as possible to mitigate the fiscal burden on the government budget from the shortfall in the Old Pension fund.

Chapter 3. Reform Measures and Projections for the Basic Pension

This section analyzes the proposed reform measures for the basic pension system and their fiscal implications. Given the high rate of elderly poverty and the substantial coverage gaps in the national pension, this study examines long-term fiscal projections for the basic pension to ensure its sustainability and enhance its effectiveness in reducing poverty. Various reform scenarios are assessed in the context of these projections to guide future policy decisions.

South Korea has one of the highest elderly poverty rates among OECD countries, largely due to the relatively recent introduction of the national pension and the fact that many older adults were unable to enroll. To address this issue, the Basic Old-Age Pension was introduced in 2008 and later restructured into the basic pension system in 2014. Currently, the basic pension provides up to approximately 333,000 KRW per month as of 2023, targeting the bottom 70% of the elderly based on their recognized income.

The current basic pension system operates on a goal coverage rate, distributing pensions to 70% of older adults. However, as the population ages and the standard pension amount increases, the fiscal pressure on the system intensifies. At the same time, as the national pension benefits increase for new retirees and economic conditions improve, the income threshold for basic pension eligibility has been rising annually. Recently, this has resulted in individuals with recognized incomes approaching 100% of the median income qualifying for the basic pension benefits. Consequently, policy discussions have emerged around improving the poverty reduction effect of the basic pension by tightening eligibility criteria, reducing the number of beneficiaries, and increasing the standard pension amount.

In this context, the study conducts fiscal projections for various reform scenarios currently under consideration for the basic pension. One scenario, proposed by Yun Seok-Myung (2023), involves fixing the eligibility threshold at its current level and indexing it to inflation. To estimate the impact of this selective reform measure on the number of beneficiaries, the study projects changes in the distribution of recognized income among future elderly populations using data from the 2014-2021 Fiscal Panel. The projections assume that the current trend in recognized income persists through 2070. The estimated distribution changes are then applied to the basic pension fiscal projection model developed by Shin Kyung-Hye and Kim Hyeong-Soo (2021) to perform the fiscal projections.

The fiscal projections reveal that maintaining the current system would result in total cumulative expenditures of approximately 3,143 trillion KRW between 2023 and 2070. In contrast, a universal expansion scenario, which increases coverage from 70% to 100% of the elderly population and raises the standard pension amount from the inflation-adjusted 333,000 KRW to 400,000 KRW from 2024 onward, would result in total cumulative expenditures of approximately 5,510 trillion KRW over the same period, which is about 75% higher than maintaining the current system. However, under the targeted improvement scenario, where the eligibility threshold is fixed at the 2023 level and indexed to inflation, the proportion of beneficiaries would gradually decrease from 70% to 23% of the elderly population each year. Even with an increase in the standard pension amount to 400,000 KRW from 2024, total expenditure would amount to 2,012 trillion KRW, a reduction of approximately 36% compared to the current system. Notably, the savings generated from reduced expenditures could increase the standard pension amount to 570,000 KRW by 2070.

It is crucial to consider the basic pension reform in conjunction with the national pension system. As the population ages and the national pension system matures, the basic pension should aim to enhance fiscal sustainability and effectiveness in poverty reduction by making eligibility criteria more targeted and increasing the standard pension amount. To achieve these objectives, the national pension must continue to fulfill its role as a public retirement income security system, while further development of the private pension system is necessary to strengthen income security provided by a multi-pillar approach. Ultimately, the basic pension could prioritize supporting the income of relatively economically disadvantaged elderly individuals, while the national pension and private pensions provide income security for those in relatively better economic conditions.

Chapter 4. Analysis of a DC-Type National Pension System Using an Overlapping Generations Model

This chapter analyzes how different age groups and income classes respond to various pension systems and economic environments by employing a heterogeneous agent overlapping generations (OLG) model within a general equilibrium framework. Unlike the financial projection model discussed in the previous chapter―which treats each gender×age×subscription period group as a homogeneous entity and does not account for endogenous changes in macroeconomic variables such as interest rates and wages―this model allows for a deeper and more nuanced analysis.

This study assumes the population structure of 2070 to examine the potential issues that may arise if the defined benefit (DB) pension system is maintained and to compare it with the responses of various age and income groups under a reformed defined contribution (DC) pension system.

In a population structure characterized by advanced aging like that of 2070, the DB pension system would require an increase in the contribution rate from 9% to 18%, yet still necessitate government support, estimated to be as high as 8.8% of GDP. In contrast, transitioning to a DC pension system would significantly reduce the government's fiscal burden and enhance the sustainability of the national pension fund. While overall production and the average living standards of the working-age population would improve under the DC system, the lower income replacement rate might exacerbate disparities. The DC system makes it more challenging to secure adequate retirement income, which could potentially widen the gap in income security between age groups compared to the DB system.

Specifically, in a DC pension system, households are likely to increase savings in preparation for retirement, leading to lower interest rates and higher wage rates, potentially worsening inequality between retirees and the working-age population. To address this, a mixed approach that uses part of the government financial support for the DB system as a supplementary support for the DC framework could be considered, providing economic benefits to both working and retired age groups. When considering a mixed approach, the DC system generally results in higher total production and post-tax income. Additionally, if the fund's rate of return exceeds the nominal growth rate, the pay-as-you-go (PAYG) pension system may become inefficient in the long term, making a DC system with government support potentially more efficient than a DB system.

Chapter 5. Directions for Public Pension System Reform

This chapter examines the legal issues surrounding national pension reforms and analyzes international cases of social consensus achieved during pension reforms in major countries. It also assesses the validity of structural reform measures for public pensions and explores the potential for restructuring the basic pension and introducing supplementary pensions to address the shortcomings of the current system. Finally, the chapter discusses issues related to South Korea’s public pension systems.

Reforming the national pension inevitably requires legislative amendments in line with constitutional principles, such as property rights, the principle of legitimate expectation, and the principle of proportionality. Legal reviews serve as an important reference, particularly Constitutional Court rulings on mandatory pension enrollment and the legality of premium collection. Adjustments to the contribution rate and income replacement rate are key measures for ensuring the financial sustainability of the national pension. While these adjustments may infringe on property rights, legislative actions that minimize the breach of trust and adhere to the principle of proportionality could be permissible within the constitutional framework.

Ideally, pension reform is achieved through broad social consensus, with active involvement from stakeholders to adjust and align various interests toward a collective agreement. However, South Korea may be ill-suited for a social dialogue-based model like Finland’s or a political consensus model like Sweden’s. The country’s low unionization rate, the absence of representative organizations for self-employed and vulnerable workers, the weak tradition of social dialogue in institutions like the Economic and Social Development Commission, and the adversarial nature of the country's two-party political system all pose challenges.

Given these challenges, the government-led consultative approach, as observed in countries like Germany, the UK, and Japan, may offer a more effective pathway for pension reform in South Korea. What is recommended in this paper is the establishment of a Pension Reform Committee composed of a small number of experts, which would be instrumental in objectively analyzing the situation and proposing directions and principles for reform, for the government to consider adopting.

The current DB pension system faces challenges in improving its fiscal sustainability solely through parametric adjustments, such as increasing contribution rates, lowering income replacement rates, or adjusting the pensionable age. These efforts are constrained by optimistic demographic assumptions underpinning policy decisions. Therefore, it is necessary to explore strategies to address potential issues from introducing a funded DC system, including investment return risks, mortality and wage growth projection errors, and income redistribution concerns. Additionally, reforms should prioritize securing retirement income adequacy.

Furthermore, the chapter discusses restructuring the basic pension and introducing the Guarantee Pension. The restructuring of the basic pension aims to protect individuals who fall outside the coverage of the national pension system, with a focus on strengthening retirement security for low-income groups. Drawing lessons from Finland and Sweden, which operate selective basic pension systems, and Canada, which has a universal system, the chapter explores the future direction of South Korea’s basic pension. South Korea should design a system that, like Finland and Sweden, targets a more limited group of beneficiaries for basic and supplementary pensions to ensure minimum retirement income for low-income seniors.

Lastly, the chapter briefly discusses proposals to enhance the national pension system, including increasing National Pension contribution rates, extending the mandatory enrollment period, raising the ceiling on standard monthly income, addressing the issue of income gaps caused by extending the pensionable age, and exploring integration options to improve equity between the national pension and occupational pensions, such as the Government Employees Pension.

Summary

Policy Study KOR Strategies for Upscaling Regional Innovation Clusters: Empricial Analysis and Case Studies

This study investigates the growth dynamics of businesses within regional clusters through empirical analysis and identifies the success factors of regional innovation clusters through case studies. Adopting a practical approach, the empirical analysis uses the data from industrial complexes―recognized as the foundation of Korea’s industrial cluster policy―in connection with the establishment level data from Mining and Manufacturing Survey. The empirical analysis addresses three questions: (1) Do businesses within clusters demonstrate superior growth performance compared to those outside? (2) What specific attributes of cluster-based businesses contribute to their growth patterns? In particular, do they demonstrate linkages with regional innovation capacity? (3) How does cluster membership influence recovery from economic crises such as the global financial crisis?

The case studies focus on Pangyo Techno Valley and the Wonju Medical Device Industry Cluster, analyzing their current status, success factors, and challenges to derive policy insights.

Key findings and policy implications are summarized as follows:

First, businesses located in industrial complexes outperform those outside both in employment and production. According to the analysis model, the businesses in industrial complexes demonstrated approximately 3~5% additional growth in employment, production, and value-added during the investigated period. This trend is consistent across most types of industrial complexes. However, their performance shows no significant correlation with the region’s innovation capacity, suggesting limited impact from the collaboration with regional innovation actors on business outcomes.

Second, there are no additional effects from the government’s cluster policies, such as Free Economic Zones and Research and Development (R&D) Special Zones, at least within the scope of the empirical analysis. While further research is needed, these findings indicate that overlapping designations and investments may dilute the effectiveness of existing cluster policies, calling for more cautious and strategic planning in future cluster policy implementation. As the Korean government is introducing Opportunity Development Zones, it should evaluate the effectiveness of previous policies and better utilize already-invested resources by connecting with existing clusters.

Third, businesses within regional clusters exhibit stronger recovery from external shocks, such as economic crises, than those outside. This advantage appears to stem from the agglomeration of industries within clusters, facilitating information sharing and access to resources. These attributes are noteworthy for building sustainable and resilient regional economic ecosystems. Moreover, the case studies reveal that the establishment and development of regional innovation clusters rely on key success factors, including leadership by regional stakeholders and the capacity to develop and manage these clusters―specifically, planning led by local actors, tight-knit collaboration among innovation actors, and cooperative governance to mobilize resources. While generalizing these findings requires caution, they provide valuable insights for fostering successful regional innovation clusters.

Summary

Research Monograph KOR Foreign Direct Investment in Korea: Performance Evaluation and Policy Implications

Countries are actively seeking ways to attract foreign direct investment (FDI) as a crucial instrument for economic growth, and Korea is no exception. The Korean government has been an ardent supporter of FDI after switching its stance on FDI as a key source of materializing its growth potential after the 1997 Asian Financial Crisis. Currently, Korea implements a wide range of support measures, such as location choice assistance by establishing Free Trades Zones, Foreign Investment Zones, and Free Economic Zones, tax reductions and exemptions, and cash grants. However, despite its extensive efforts, the inflow of FDI remains small, while the outflow of FDI by domestic firms continues to rise.

Underlying this stance is a hypothesis that the gain outweighs the cost, which means the positive ripple effects of FDI on the overall Korean economy are greater than the monetary value of incentives given to foreign investors. Still, that hypothesis needs to be verified. As for the productivity spillover effects of FDI in Korea, the prior empirical studies show mixed results, both positive and negative or ineffective. Also, previous studies empirically comparing foreign-invested enterprises’ performance with domestic firms had contradictory results.

Such conflicting conclusions are primarily due to statistical restraints. The scope of data on foreign-invested firms studied previously is narrow because information disclosed by the government is extremely limited. In order to overcome this shortfall, this study employs a complete enumeration of data on foreign-invested enterprises operating in Korea, provided by the Ministry of Trade, Industry and Energy, to analyze their business performance as follows. First, an analysis method of propensity score matching is used to see if there is a significant difference in operational performance between foreign-invested and domestic companies in the manufacturing and services industries at the enterprise level. Second, it also estimates the effect of FDI on the productivity of domestic firms in the manufacturing industry. Accordingly, this study calculates their firm-level productivity to estimate the effect of productivity spillovers from FDI, taking into account foreign-invested companies’ impacts on their local competitors as well as on upstream and downstream domestic companies.

This study analyzes firms operational on the 2019 KIS-DATA using a control group of domestic firms similar to foreign-invested firms in terms of firm age, size, wage level, and debt ratio. The results are summarized as follows. First, as to two productivity indicators, labor productivity and per capita operating profit, it finds no empirical evidence to support the hypothesis that foreign-invested companies perform better than domestic ones in manufacturing and service industries. Rather, domestic firms outperformed their foreign competitors in the service industry. Second, in terms of growth potential measured by the average annual growth rates of per capita value-added and sales over the past five years (2015-2019), there is no empirical evidence to support the hypothesis of better growth potential among foreign-invested companies. Third, as to innovation capacity measured by the proportion of R&D expenditures and costs of education and training to sales, no empirical evidence is found to support the hypothesis of a higher level of innovation for foreign-invested firms in the manufacturing industry than their domestic counterparts. However, the analysis finds that R&D intensity in the service industry was much more significant for foreign-invested companies.

This study also examines business establishments operational on Statistics Korea’s 2003-2009 Mining and Manufacturing Survey to see the effect of FDI enterprises on the productivity of domestic manufacturing firms. First, it finds the productivity of foreign-invested companies in the mining and manufacturing industries to be 8% higher than that of local competitors after controlling for other effects. Second, the analysis using level statistics finds the impact of FDI on the production of domestic firms to be negative in all cases of the competition effect on the same industry, forward linkage effect on the productivity of the downstream sectors as foreign-invested companies supply intermediate goods to them, and backward linkage effect on the productivity of the upstream industries as foreign-invested companies consume the output from them. However, large-sized foreign-invested enterprises positively impacted the productivity of other firms in the same industry. Third, the result shows that the growth of highly productive foreign-invested companies positively influenced the productivity of upstream firms. Such a positive effect appears to grow over time and become stronger for the larger foreign-invested firms. While no positive effect was observed for the same industry and downstream industries with time, FDI had a significantly more positive impact on the productivity growth rate of industries with a high share of the production of intermediate goods.

In conclusion, the finding that FDI negatively impacts the productivity of domestic firms raises a serious question as to whether Korea’s foreign investment support policy has effectively achieved its intended goals. A key implication from the results of this study is that future FDI policies should focus more on quality over quantity. To this end, the Korean government needs to develop a comprehensive index model that can measure not just the total amount of FDI but also the positive effect of foreign-invested companies on the Korean economy in various aspects like productivity and employment. Moreover, this index should be utilized to evaluate and further advance FDI support policies. Currently, the criteria for government assistance to attract foreign investment are confined to the amount of investment and the size of employment, but more diverse indicators need to be incorporated, taking into account growth potential. Furthermore, the government should shift its focus to attracting quality multinationals as well as creating a business environment conducive to their growth and sustainable development in the host country.

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