Fifty million Koreans will count on the Korean National Pension Plan in their retirement years. Clearly, managing the $406 billion national pension fund in the best manner possible is one of the most critical missions of the national government, right next to national defense and economic growth. Is the Korean national pension fund being managed well? Let’s consider the quality of the national pension fund by three criteria: safety of the assets, rate of return on the portfolio, and steadiness of the rate of return on portfolio.

The safety of an asset refers to the likelihood of suffering capital loss. Nobody would dispute that the national pension plan ought to invest in safe assets. The safe asset, however, depends on the investment horizon: If the investment period is only an hour long, cash is the safest asset to hold; if the investment period is one year, the safest asset is not cash but instead an interest-bearing instrument, considering the inflation and the opportunity cost. Hence, the safety of an asset must be considered in the context of the rate of expected return on the asset for the relevant investment horizon.

Between stocks and bonds, stocks would have a higher expected rate of return than bonds to compensate for taking on greater risk. This intuitive, or theoretical, supposition is incontrovertibly supported by historical data. The rates of return adjusted for inflation in the U.S. for the 80-year period between 1926 and 2005 show that $1 invested in stocks in 1926 turned into $302 in 2005, while $1 invested in bonds turned into less than $10. Korean experience in the last 30 years with stocks and bonds also show that stocks hugely outperformed bonds. Hence, given that the Korean National Pension Plan has a semi-infinite investment time horizon, the pension plan ought to allocate a larger portion of its fund to stocks than bonds, considering the huge difference in the expected rates of return on the two asset classes.

As of March 2013, the Korean National Pension Plan invested 63.8 percent of the $405.9 billion fund, or $259.1 billion, in bonds. What is the rationale for investing such a huge portion of the fund in bonds whose long term rate of return is far inferior to that of stocks? One may answer it by saying that bonds are safer than stocks. We argued above such reasoning is flawed because what constitutes a safe asset depends on the relevant investment period. Investing 62.8 percent of the pension fund in bonds is analogous for a shipping company to keeping 62.8 percent of its fleet in harbors. If a shipping company keeps most of its boats in harbors, the fleet might be safe but the company will soon be in financial peril. Likewise, investing such a large portion of the fund in bonds is in the long run very dangerous to the solvency of the pension fund.

Investing 62.8 percent of the plan’s fund in bonds is a particularly poor idea under the current market situation where the interest rates worldwide are at their lowest level in decades: Not only do bonds yield a puny rate of return, but they will also soon depreciate in market value, as the interest rates can only rise in the future. Hence, the Korean Nation Pension Plan should promptly reallocate its fund, at least 90 percent of it to stocks and other equity-like assets and less than 10 percent of it to bonds. And, the sooner the reallocation is done, the better off the fund would be.

Let’s now consider the stability of fund’s rate of return. In general, we would prefer a lower variability in the fund’s rate of return from one year to the next. The standard modus operandi for achieving this goal is to diversify the asset classes in the fund’s portfolio as well as the issuers within a particular asset class. For instance, the rate of return would be less volatile if $50 million each is invested in both Samsung and Hyundai than if all $100 million is invested in just one of the two firms. The logic of the modus operandi in reducing variability of rate of return can be extended from a single domestic asset market to global asset markets. At present, 85 percent of the fund that is invested in stocks and bonds is kept within Korea. Given that Korean GDP is less than 2 percent of the global GDP aggregate, it is only reasonable to gradually raise the portion of non-Korean assets to above 80 percent of the pension fund.

For a small-sized fund, a successful management of the fund would depend mainly on individual assets chosen for the portfolio. For a huge fund such as the Korean National Pension Plan, the success of the fund would depend critically on the fund allocation among different asset classes, such as stocks and bonds. Hence, the future success of the national pension fund would depend on how quickly the proposed reallocation of fund (i.e., 90 percent in stocks and 10 percent in bonds) and the proposed global diversification of assets (i.e., 80 percent non-Korean and 20 percent Korean) are adopted.

An organizational revamping is also needed to better manage the national pension fund. Currently, a committee of 20 chaired by the head of the Health and Welfare Ministry has the ultimate oversight authority over the management of the pension fund. Given the vital importance of the national pension plan for 50 million Koreans, the management of $406 billion fund ought to be supervised by a committee consisting of the most senior government officers in economics and finance fields such as the heads of Strategy and Finance Ministry and the Bank of Korea, and the Blue House senior assistant to the president. The people who are responsible for the day-to-day management of the fund should also be of the best caliber that Korea can offer ― people who are better qualified than their counterparts in the private investment management sector and have international experiences and global perspectives.

Koreans had worked hard for decades to build an industrialized country on the ruins of the Korean War, only to risk in the blink of an eye the cream of its industrial achievements in the so-called IMF crisis of 1997. The deeply painful experience was attributable to the Korea’s then collective lack of financial sophistication. Korea must never suffer another financial folly like that. Rather, Korea should quickly evolve into a country whose financial sophistication matches its world-class industrial strength. The Korean Nation Pension Plan in particular ought to invest in U.S. assets as well as Chinese assets; it also ought to invest in fast-growing economies of the Southeast Asian countries as well as resource-rich countries such as Australia, Canada, South American countries, etc. By investing wisely throughout the globe, the Korean National Pension Plan can better secure retirement incomes of 50 million Koreans, and it can also help Korea become a financial powerhouse in the world stage. 

By Kenneth S. Choie

Kenneth S. Choie is a professor of finance at Sejong University. Formerly, he was a portfolio manager at UBS in New York. He earned his Ph.D. in economics and finance from the University of Michigan. He can be reached at kchoie@sejong.ac.kr. ― Ed.