[Practical Finance] Build a Three-Tier Pension Tower... Strengthen Your Retirement Planning

Tips for Retirement Preparation in the COVID-19 Era

[Asia Economy Reporter Kangwook Cho] The digital untact era is rapidly approaching due to the novel coronavirus infection (COVID-19). The elderly population living in this unprecedented untact era in human history must find new retirement plans suited to the new era. Currently, the three-tier pension system for old-age security is a global trend. The three-tier pension system was formally proposed in the 1994 World Bank report titled 'The Averting Old-age Crisis.' It emphasized a multi-pillar pension system to complement public pensions with private pensions (retirement and personal pensions) to address the vulnerability of relying solely on public pensions for old-age income security.

1st Tier National Pension, 2nd Tier Retirement Pension, 3rd Tier Personal Pension... Secure 50-70% of Pre-Retirement Income as Pension Income

Korea's three-tier pension system consists of the 1st tier public pension such as the National Pension, the 2nd tier retirement pension, and the 3rd tier personal pension. The National Pension is mandatory for all citizens, and the retirement pension is provided by companies for their employees. But is this enough? Depending on the expected standard of living, there are concerns that the National Pension and retirement pension alone do not provide sufficient old-age security. Shinhan Bank recently advised in its 'Shinhan Future Planning Report 2020' that a personal pension should be added on top of the National Pension and retirement pension to build a three-tier pension tower. The report's main point is that securing pension income at 50-70% of pre-retirement income through the three-tier pension is necessary to maintain a lifestyle similar to before retirement.

Opening an IRP Account to Also Aim for Tax Benefits

◆ Accumulate Retirement Pension While Working and Aim for Tax Benefits with Individual IRP = The retirement pension accumulates steadily as long as you work at a company and mainly consists of defined benefit (DB) and defined contribution (DC) plans. The defined benefit plan guarantees a fixed retirement benefit amount, whereas the defined contribution plan allows the employee to manage the funds directly, so returns may vary depending on investment performance. Check which retirement pension plan you are enrolled in, and if you are a DC plan participant who manages the funds yourself, regularly manage your investments to improve retirement pension returns.

The Individual Retirement Pension (IRP) is a type of retirement pension account introduced on July 26, 2012, following the amendment of the Employee Retirement Benefit Security Act. Although it is a retirement pension, it also has characteristics of a personal pension because of its tax benefits and the ability for participants to make additional contributions. Employees can accumulate severance pay each time they change jobs before retirement, make additional voluntary contributions, manage the funds, and later use them as pension or retirement funds. When receiving severance pay, employees must open an individual IRP account to deposit it, and contributions beyond severance pay are eligible for tax deductions similar to pension savings.

Personal Pension Savings Funds, Pension Savings Insurance, Pension Insurance... Individuals Can Join and Manage Through General Financial Institutions

◆ Preparing Another Pension? Pension Savings Funds, Pension Savings Insurance, Pension Insurance = Personal pension products that individuals can join and manage through general financial institutions include pension savings funds, pension savings insurance, and pension insurance. Previously, pension savings trusts existed, but new subscriptions are no longer possible; only additional payments to existing accounts are allowed.

Pension savings insurance is a pension product in the form of insurance where a fixed amount is paid monthly over a long period. Insurance-related costs are deducted upfront at the time of payment, but these costs decrease over time, and compound interest effects appear. Pensions can be received as a lifetime annuity or divided over a fixed period.

Pension savings funds allow free deposits into an account and operate as funds to generate returns. Although principal loss is possible, it offers higher expected returns, which is advantageous in a low-interest-rate environment. The biggest feature of pension savings insurance and pension savings funds is that they are 'tax-qualified' products with tax deduction benefits. In contrast, pension insurance is similar to pension savings insurance but is a 'non-tax-qualified' product without tax deduction benefits, instead offering tax exemption benefits upon pension receipt.

◆ Refunds Up to 16.5%... Be Careful of Other Income Tax When Terminating Early = The biggest common feature of individual IRP and pension savings is that they are tax-qualified products eligible for tax deductions. Depending on income, 16.5% or 13.2% of the annual contribution amount is refunded in cash during year-end tax settlement. Considering tax benefits as an interest rate, there is no more stable and certain financial strategy. Since this is retirement preparation money for oneself and taxes are refunded, there is no reason to refuse. Especially, from this year for three years, those aged 50 or older have an increased annual tax deduction limit by 2 million KRW.

When pension account contributions are received as pensions, pension income tax (low-rate taxation, 3.3-5.5% depending on age) is imposed. However, if terminated early, other income tax (16.5%) is imposed instead of pension income tax. Therefore, if pension accounts are terminated early without receiving pensions, a higher tax rate applies, so caution is needed. Especially if tax benefits received during the contribution period were less than 16.5%, it could result in a loss. In cases of unavoidable termination or early withdrawal, low-rate pension income tax is applied.

Unavoidable termination reasons include death, overseas migration, natural disasters, suspension of savings institution operations, treatment of the subscriber or dependents for more than three months, retirement and business closure, personal rehabilitation, bankruptcy declaration, etc., and termination applications must be made within six months of the occurrence to be recognized. Unavoidable early withdrawal reasons include home purchase or deposit for the homeless, nursing care for oneself, spouse, or dependents for more than six months, bankruptcy or personal rehabilitation within the last five years, natural disasters, etc. Withdrawals for home purchase or deposit purposes by the homeless are subject to other income tax, so caution is required.

◆ Long-term Products That Reinvest Taxes to Generate Returns = General financial products withhold interest income tax at maturity and pay only the after-tax interest. However, when managing products through pension accounts, taxes on operating profits are imposed only upon account termination or pension receipt. In other words, taxes on profits generated through pension accounts are deferred until pension receipt, and no taxes are paid while the pension account is active. Therefore, the amount corresponding to taxes can be reinvested, potentially generating higher returns.

Compared to fixed deposits, which impose a 15.4% interest income tax on interest at maturity, pension accounts defer tax on investment profits and allow reinvestment, resulting in higher returns the longer they are managed.

Pension accounts are long-term products operated with compound interest, so even a slight increase in annual returns can significantly change the balance after 5, 10, or 20 years. Experts advise selecting and managing financial products that suit market conditions and personal investment preferences to actively increase returns. If self-management is difficult, consulting financial institution experts or using mobile asset management services provided by the financial institution where the pension account is held is also a good option.