Do You Know the Three-Tier Pension System?

 Nowadays, people are more interested in various types of investments, from stocks and cryptocurrencies to bonds, 

 Nowadays, people are more interested in various types of investments, from stocks and cryptocurrencies to bonds, gold, and dollars. However, one crucial aspect of financial planning that often gets neglected is pensions. Having a solid plan for retirement is essential, and there's no such thing as being too young to start thinking about it! Let me, your guide from Appt, help you understand pensions thoroughly and become a pension wizard.

<Pension Wizard> Previous Series Recap

Last time, we explored the meaning of financial planning and the importance of pensions. Today, we will start discussing pensions in detail, beginning with an overview of South Korea’s three-tier pension system, illustrated for better understanding.

Tier 1: National Pension – Mandatory for Income Earners

Planning for retirement isn't just a personal concern; it's a significant issue for the government as well. If people aren't well-prepared for their retirement, social costs increase. Therefore, the government manages some pensions directly and offers tax benefits and other supports to encourage personal pension planning.

The pension managed directly by the government is the **National Pension** (Tier 1). The National Pension is a public pension system created to guarantee the basic living standards of the population. Anyone with income must participate in it.

You might have heard of the "Four Major Insurances" if you are employed. These include the National Pension, Health Insurance, Industrial Accident Insurance, and Employment Insurance. Before paying wages, companies deduct contributions for these insurances, along with income taxes, and pay them to the government. This process is known as "withholding."

The National Pension Fund is managed by the National Pension Service and invested in various areas to generate returns and fund retirement benefits. This is why you often hear news about the National Pension’s stock holdings or investment returns.

The mandatory contributions to the National Pension will later serve as funds to support your basic living expenses in retirement. You can start receiving it from the age of 65.

Tier 2: Retirement Pension – A Necessary Condition for Stable Retirement

Moving on to Tier 2, the **Retirement Pension** is accumulated by companies for employees as a part of their retirement planning. If you receive a salary, you are considered to have earned income, and the Retirement Pension system is semi-mandatory.

This pension has undergone significant changes recently. Since many of our subscribers are employees, this topic is crucial and will be explained in more detail later.

With both the National Pension and Retirement Pension properly set up, you can achieve a "stable living" in retirement. The Retirement Pension can be received starting at age 55.

Tier 3: Personal Pension – A Choice for Comfortable Living

The final tier, Tier 3, is the Personal Pension. Unlike the mandatory public pensions of Tiers 1 and 2, Personal Pensions are voluntary. These are private pensions that individuals can choose to invest in with financial institutions.

Personal pensions include:

- Pension Savings Trusts from banks

- Pension Savings Funds from securities firms

- Pension Savings Insurance from insurance companies

Each product has its own features, advantages, and disadvantages, which will be explained in more detail later.

Having a well-planned National Pension, Retirement Pension, and Personal Pension generally means you can enjoy a "comfortable living" in retirement. Personal pensions, like Retirement Pensions, can typically be accessed from age 55.

When and How Much Can You Receive from Each Pension?

The commonality among the three pensions is that they involve saving a portion of your income while you are earning, which will then be received as pension benefits when you are no longer able to work.

In South Korea, the legal retirement age is 60 (as of 2024). The National Pension allows you to choose to start receiving benefits from age 65. Retirement and Personal Pensions can start being received from age 55.

Even though the legal retirement age is 60, some people may retire earlier, so it’s important to have enough income or assets to cover expenses until the pensions begin. If your assets are insufficient, you may need to start receiving Retirement or Personal Pensions as early as 55.

So, how much will each pension contribute to your required income? To answer this, you need to understand the "replacement rate." The replacement rate shows what percentage of your average lifetime income (average lifetime earnings) your monthly pension amount will be. For example, if your average lifetime income is 3 million won and the replacement rate is 40%, your future monthly pension amount would be around 1.2 million won in nominal terms.

The term "nominal" refers to calculations made without adjusting for inflation. The National Pension is adjusted for inflation, and Retirement and Personal Pensions are managed to at least keep up with inflation. Therefore, it’s challenging to precisely predict future pension amounts.

The National Pension has undergone several changes in pension starting age and replacement rates due to concerns about fund shortages as the population declines and the baby boomer generation reaches retirement age. Thus, the starting age has been postponed and the replacement rate adjusted.

The Retirement Pension system, still relatively new, varies greatly depending on individual management. Typically, a 30-year contribution period starting at age 60 might achieve a replacement rate of 18-20%.

By effectively managing your Retirement Pension and combining it with the National Pension to achieve a replacement rate of 58-60%, you could receive about 60% of your average lifetime income monthly. The remaining 40% depends on how well you plan and prepare.