[Insight & Opinion] Korean Pension Investors Vulnerable to Inflation Risk

87% of Pension Portfolios in Principal-Protected Products
Little Preparation for Declining Currency Value
Need to Increase Equity Allocation Through Global Diversification

There are five risks we must face upon retirement: longevity risk, inflation risk, market risk, interest rate risk, and sequence of returns risk.

Longevity risk literally refers to the risk of living a long life. Lawrence Kotlikoff, a professor of economics at Boston University, asserts from an economic perspective that “longevity is a wonderful thing to imagine, but from an economic standpoint, it is a nightmare.” Living a long life entails significant costs. Inflation risk means the decline in the value of money. If we fail to earn returns above the inflation rate during a long retirement, we effectively pay an invisible tax. For example, if the inflation rate remains at 3%, the value of our money halves approximately every 20 years.

Market risk refers to situations such as a stock market crash. If one holds stock assets in their portfolio and a crisis like the 2008 financial crisis occurs at retirement, it would cause severe damage. Interest rate risk refers to the risk arising from changes in interest rates. It means that the price of bonds held may fall due to interest rate changes or that deposit yields are low due to excessively low interest rates. The core of sequence of returns risk is that if returns are low in the early years of retirement, one must endure difficult circumstances throughout retirement. Various simulation studies show that asset management in the first 10 years after retirement determines the overall quality of retirement life. Therefore, planning and strategy for asset management in the first 10 years post-retirement are crucial.

Domestic investors are still insufficiently prepared for these five risks. While all five are lacking, it is no exaggeration to say that there is virtually no concern about inflation risk. Since pensions are intended to cover living expenses in old age, they must generate returns exceeding inflation over the long term. It is already established that bonds or deposits cannot hedge against inflation. This is mentioned in every investment textbook. In countries like the United States, Australia, and Sweden, very few investors invest solely in so-called safe assets such as deposits or bonds. Most manage their pensions based on stock assets. As of the end of 2023, 87% of Korean pension investors’ portfolios are principal-guaranteed products. This is an abnormally high proportion of principal-guaranteed investments.

If there were an investment that could steadily generate returns over a long period without a single negative year, it would be the ultimate ideal. A combination of stability and profitability, the dream investment for everyone. Unfortunately, such an investment does not exist in reality.

There was a legendary fund that delivered annual returns of 10-12% to investors for 38 years, even through market crashes and surges. This was the fund managed by Bernard Madoff in the United States. The list of investors in this fund included famous figures such as film director Steven Spielberg and global financial institutions. However, this fund was ultimately revealed as the largest Ponzi scheme in U.S. history.

In the world of investing, a perfect combination of stability and profitability does not exist. Deposits, considered safe, are vulnerable to inflation risk, and investments promising high returns cannot avoid the risk of price declines. Pursuing only stability or only high returns cannot sustain precious pensions over the long term. Appropriate asset allocation must be made according to one’s temperament and financial situation.

The current asset allocation of Korean pension investors is abnormal by global standards and from the perspective of long-term risk management. The proportion of stock assets should be increased through global diversification. It is time to consider that pensions must increase assets over the long term and generate returns exceeding inflation.

Lee Sang-geon, Head of Mirae Asset Investment and Pension Center