State pension fund needs diversifications

The Korea Times

The Korea Times

Opinion

Wed, November 29, 2023 | 17:01

Times Forum

State pension fund needs diversifications

Posted : 2018-12-10 17:26

Updated : 2018-12-10 17:26

By Dr. Jeffrey I. Kim

South Korea desperately needs to strengthen the asset management expertise of its National Pension Fund. As of September 2018, the fund is estimated at 654 trillion won ($581 billion) in assets, the world's third-largest.

Yet many younger people in Korea are worried the fund will be depleted before they become eligible to receive a pension.

According to the National Pension Service (NPS), the pension fund will be depleted by 2057. This problem stemmed from several factors such as the long-term trend of sluggish growth and low interest rates on the revenue side and the increase in the average life expectancy and the decline in the birthrate on the payment side.

So a lot of pension subscribers are voicing outrage over the NPS' allegedly mishandling of the fund and its plan to raise premiums, reduce pension payments and prolong the payment age. To delay fund depletion, the government must seek the best way to diversify the fund. Also it should try to get as much public support as possible before increasing subscribers' pension premiums.

Actually there is no magic prescription for the optimum diversification of the state pension fund. For any investment, higher returns call for greater risks. Unlike the private individual investors, the state pension manager, being conservative, cannot take on risk above a certain level.

The top manager's performance is regularly evaluated by the National Assembly and by the Board of Audit and Inspection. The fund managers must keep on trying to improve their diversified portfolios while complying with the changing conditions for investment.

The simplest example of diversification is provided by the proverb, "Do not put all your eggs in one basket." But using numerous baskets may increase operating costs, so an appropriate diversification of investment risks is required. Diversification reduces the risk of investment.

If you hold just one investment and it performs badly, you may lose all of your money. But if you split the investments into a variety of different investments, it will be much less likely that all of your investments will perform badly. The profits you earn on some investments will offset the losses on other investments.

We ordinarily observe that bonds and stocks move in opposite directions. When investors expect the economy to weaken and corporate profits to drop, stock prices will likely fall. When this happens, central banks may cut interest rates to reduce borrowing costs and stimulate spending. This causes bond prices to rise.

If your portfolio includes both stocks and bonds, the increase in the value of bonds will help offset the decrease in the value of stocks.

For investment of the state pension fund, there are four layers of diversification to consider. They are: (1) diversifying by asset classes, (2) diversifying by industry, (3) diversifying by country, and (4) diversifying by pension management.

The first layer is to diversify the investment across different asset classes. Shares, bonds, property and cash belong to different asset classes. The prices of these assets tend to move in different directions. So diversifying by asset classes reduces risks given the potential returns.

The second layer is to diversify across different industries. There can be numerous industries issuing stocks and bonds such as financial services, telecommunication services, energy, industrials and healthcare. So diversifying by industry helps to reduce investment risks given the potential returns.

The third layer is to diversify across different countries. Developed market countries may be less risky than countries in emerging markets. International investors check country risk rankings. So adding foreign investments in the portfolio may help the investor to improve portfolio diversification.

The fourth layer of diversification applies more to the investment of state pension. The government would not want to leave the nation's hugest pension fund under one "management basket."

The government should explore strategically splitting the nation's sovereign fund in such a way that top managers may compete with one another in operating their fund. The government must receive enough public support to raise subscribers' premiums.

In assigning the top managers into the pension fund, the government should recognize the differences between short-term and long-term investments and between the local and overseas markets.

Dr. Jeffrey I. Kim (ickim@skku.ac.kr), former foreign investment ombudsman, is a professor emeritus at Sungkyunkwan University. He earned a Ph.D. in economics at the University of Chicago and taught at the University of Colorado, Boulder, and the American University, Washington, D.C.