Korea Pension Investment

Starting this year, as I have been residing in the United States, I became curious about the U.S. pension system and decided to do a bit of research. While there are many types of pension plans in the United States, and I’m by no means a tax expert, I thought I’d write a little on this topic in case it might be helpful. As mentioned earlier, there are various types, and the United States, with its individual business owner retirement plans, healthcare for one’s retirement years, child education funds, and more, has such a wide range of pension options that it’s challenging to cover everything. Instead, in this blog, I will focus on the pension systems and retirement preparation concepts in South Korea and the United States, primarily targeting employees (profit-based companies).

In conclusion, there isn’t a 100% exact match between South Korean and U.S. pension accounts or systems. Even though they may seem somewhat similar, there are slight differences that make a one-to-one comparison challenging. Since direct comparisons are difficult, I’ve categorized them to provide a somewhat similar structure, as outlined below.



Type	Korea	US	Remark
National/Federal Fund	National Pension Fund	Social Security Retirement	First Layer
Individual / Company Pension	Retirement Pension (DC/DB)	401(k)	Second Layer
Individual Pension	Pension Saving Fund	Traditional IRA	Third Layer
	IRP
	–	Roth IRA



The easiest to understand would be the National/Federal Pensions. As of the time of writing, in South Korea, employees and employers each contribute 4.5% of the employee’s salary, totaling 9.0% collected. In the United States, 6.2% of the salary is contributed, with employees and employers each paying half, totaling 12.4%. Both require a qualification period of over 10 years to receive pension benefits. In South Korea, they provide a statement detailing the national pension contributions and the expected pension amount upon retirement, but honestly, whether you’ll receive it is uncertain! In the United States, the pension amount varies depending on the retirement age. As of 2023, the full retirement age is 67, with a monthly benefit of $3,627. At age 62, it’s $2,572 per month, and at age 70, it’s $4,555 per month.

Secondly, we can categorize pensions at the individual/company level. The retirement pension we are familiar with can be divided into DB/DC types, where an equivalent of one month’s salary is accrued per year. In the United States, there’s a somewhat similar pension supported at the corporate level called the 401(k) program. The 401(k) program is offered by for-profit companies, and a similar program targeting employees working for non-profit organizations or government agencies is known as the 403(b) program. This concept involves employees contributing a certain percentage of their salary to the 401(k) program, and the company typically matches a portion or the entire contribution, which is known as “matching.” For instance, if a company matches a 4% contribution from an employee earning a $100,000 salary, the employee contributes $4,000, and the company contributes an equal $4,000, for a total of $8,000 invested annually. Since the company supports this program, it’s essentially a guaranteed 100% return, making it quite an attractive option. The key features are as follows:

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401(k)

• Employee/employer annual maximum contribution limit of $22,500 or $30,000 (for those aged 50 and older).
• Employee/employer combined maximum contribution limit of $61,000 or $67,500 (for those aged 50 and older).
• Tax-free until withdrawal (tax-deferred growth possible).

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While 401(k) is indeed a great program, it might be a bit insufficient for comfortable retirement savings. To complement this aspect, additional personal retirement investments are often necessary. In Korea, you can invest through pension savings funds and IRP accounts, while in the United States, you have the option of investing through Traditional IRA or Roth IRA. Here are the key features of Traditional IRA and Roth IRA.

Traditional IRA

• Tax-deductible: Contributions are tax-deductible.
• Tax Treatment: Earnings are tax-deferred, and they are taxed upon withdrawal.
• Required Minimum Distributions (RMDs): Mandatory minimum distribution must begin at age 72.
• Early Withdrawals: If withdrawn before age 59.5, a 10% penalty applies.
• No Income Limits: There are no income limits for contributions.
• Contribution Limits: As of 2023, the limit is $6,500 ($7,500 for those aged 50 and older).

Roth IRA

• Non Tax-deductible: Contributions are not tax-deductible.
• Tax Treatment: Earnings are tax-free.
• No Required Minimum Distributions: There are no mandatory minimum distributions.
• Early Withdrawals: Contributions can be withdrawn penalty-free.
• Income Limits: There are income limits for contributions – $153,000 per year for singles and $228,000 per year for married couples.
• Contribution Limits: As of 2023, the limit is $6,500 ($7,500 for those aged 50 and older).

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In essence, the concept is to receive tax benefits upfront with a Traditional IRA and pay taxes on earnings later, whereas with a Roth IRA, you don’t receive immediate tax benefits, but your earnings are tax-free in the future. If you have a short investment horizon, taking advantage of the tax benefits with a Traditional IRA might be the better choice. However, for long-term investments, a Roth IRA, where you don’t pay taxes on earnings, is likely the superior option. If it were up to me, I would choose a Roth IRA without a doubt.

However, there is one issue. There are income limitations for those eligible to operate a Roth IRA. Fortunately, there is a workaround called the Backdoor Roth IRA. This method involves contributing to a Traditional IRA, which has no income restrictions, and then immediately transferring the funds to a Roth IRA. There have been discussions in the United States about potentially making this method illegal, but as of now, it is a widely known and used strategy. In Korea, pension savings funds and IRPs are somewhat similar to Traditional IRAs. They offer some tax deductions upfront but tax the earnings later. However, in Korea, even earnings beyond a certain limit are subject to taxation, unlike in the United States where they are not. It would be nice if Korea followed the US model and didn’t tax the earnings beyond the tax deduction limit!

Exchange-traded funds (ETFs) have revolutionized the way investors access international markets. They provide a convenient way to gain exposure to a wide range of assets, from stocks and bonds to commodities and currencies. When investing in ETFs, one important decision investors face is whether to choose currency-hedged or unhedged ETFs. In this blog post, we’ll delve into the key differences between these two approaches and analyze their respective results to help you make an informed investment decision.

Understanding Currency Risk

Before we dive into the analysis, let’s first understand what currency risk is and why it matters to investors.

Currency risk, also known as exchange rate risk, arises when you invest in assets denominated in a foreign currency. Changes in exchange rates can significantly impact the returns on your investments. If your domestic currency strengthens against the foreign currency in which your investments are denominated, you may experience currency-related losses. Conversely, if your domestic currency weakens, you may gain from the exchange rate movement. Currency-hedged and unhedged ETFs provide different approaches to managing this currency risk.

Currency-Hedged ETFs

Currency-hedged ETFs are designed to mitigate the impact of currency fluctuations on your investment returns. These funds use financial instruments, such as forward contracts, to offset the currency exposure. As a result, when you invest in a currency-hedged ETF, you’re essentially isolating the performance of the underlying assets from currency movements.

Pros of Currency-Hedged ETFs:
Reduced Currency Risk: Currency-hedged ETFs can provide a more stable return profile by eliminating the impact of currency fluctuations.

Cons of Currency-Hedged ETFs:
Higher Costs: Currency hedging comes with additional costs, which can result in slightly higher expense ratios compared to unhedged counterparts.

Unhedged ETFs

Unhedged ETFs, on the other hand, do not attempt to mitigate currency risk. When you invest in these funds, your returns will reflect both the performance of the underlying assets and the changes in exchange rates.

Pros of Unhedged ETFs:

Lower Costs: Unhedged ETFs typically have lower expense ratios since they don’t incur the expenses associated with currency hedging.
Currency Upside: In a scenario where your domestic currency weakens against the foreign currency, you could benefit from currency appreciation.

Cons of Unhedged ETFs:

Currency Volatility: Your returns can be highly volatile due to currency fluctuations, potentially leading to unexpected losses.

In an effort to provide an illustrative example, I wanted to discuss domestic listings of U.S. S&P 500 and Nasdaq 100 ETFs. However, the competition among institutions in this space is intense, resulting in minimal differences in the fees for hedged and unhedged options. Whether you choose a hedged or unhedged index fund, the annual expense ratio typically falls within the range of 0.05% to 0.3%. Even to secure the top spot, the fees for the same product offered by the second to fifth-ranked institutions remain exceptionally low. As of the time of writing, the TIGER U.S. S&P 500 Futures(H) ETF, which is hedged to the S&P 500 ETF, boasts the largest market capitalization among such products at KRW 278.6 billion, with an annual expense ratio of 0.3%. In contrast, the KODEX U.S. S&P 500 Futures(H) ETF, the second-largest in market capitalization at KRW 141.6 billion, charges an annual expense ratio of only 0.05%. While this is a favorable situation for consumers, it remains uncertain whether this will persist over time.

As such, I’ve taken the liberty of examining ETFs listed in the U.S., focusing on those that target relatively stable currencies like the USD and GBP. For comparison, I’ve selected the iShares MSCI United Kingdom ETF (Ticker: EWU) and the iShares Currency Hedged MSCI United Kingdom ETF (Ticker: HEWU), both of which are listed in the U.S. Comparing their fees reveals the following:

In this case as well, it appears that there is competition in the market, with some providers waiving related costs through promotions until 2025, aligning the fees with those of unhedged products. Upon inspecting the composition of HEWU, we find that it includes GBP/USD forward contracts in its holdings. This suggests that additional expenses are incurred for currency hedging operations and personnel costs, contributing to the slightly higher fees.

Analyzing the Results

To determine whether currency-hedged or unhedged ETFs are more suitable for your investment goals, it’s crucial to analyze historical data, your risk tolerance, and your investment horizon.

Short-Term vs. Long-Term: For short-term investors or those with low risk tolerance, currency-hedged ETFs may be a better choice, as they offer stability. However, long-term investors with a higher risk appetite might opt for unhedged ETFs to potentially capitalize on currency fluctuations.

Historical Performance: Review the historical performance of both currency-hedged and unhedged ETFs in the regions or countries you’re interested in. This will give you insights into how each strategy has fared in different market conditions.

Diversification: Consider how currency exposure fits into your overall portfolio. Diversifying across currency-hedged and unhedged ETFs can be a balanced approach.

Costs: Don’t forget to compare the expense ratios of the ETFs you’re considering. Lower costs can have a substantial impact on your long-term returns.

Conclusion

The choice between currency-hedged and unhedged ETFs depends on your investment objectives, risk tolerance, and time horizon. There is no one-size-fits-all answer. By understanding the pros and cons of each approach and analyzing historical performance, you can make an informed decision that aligns with your financial goals. Whether you prioritize stability or are willing to embrace currency fluctuations for potential gains, ETFs offer flexible options for international investing.

-> Personally, I invest in unhedged products as I have a long-term investment horizon, and these products offer exposure to both the U.S. dollar and the target asset. When approaching the market from the perspective that downturns may occur in the U.S. financial market, leading to a significant drop in index values, the USD/KRW exchange rate could see a sharp increase. This could partially offset the losses. Looking at historical events like the dot-com bubble and the 2008 financial crisis, we observed that exchange rates surged. However, if a Black Swan event or similar occurrence were to take place at the time of retirement and withdrawal, it could pose a challenge. By investing in unhedged products, I anticipate that a significant portion of currency risk can be mitigated. Conversely, what if the Korean economy is performing exceptionally well, and the U.S. dollar is flowing abundantly, causing the exchange rate to continuously decline? In that case, wouldn’t it be beneficial to hold some premium Korean stocks? 🙂

-> Some may argue that strategies can be employed, such as investing in hedged products when exchange rates are high and switching to unhedged products when they are low. While this may seem like an ideal approach, predicting factors like interest rates, exchange rates, and stock pricing is, in my opinion, nonsensical. As Peter Lynch once said, “If you predict the interest rate 3 times, you could be a billionaire. Even the chairman of FED can’t predict the rate, how can the average person predict them?” However, what we do know is the historical returns of the U.S. market, the upward trend of indices, and the consolidation of exchange rates. Therefore, for long-term investments, I believe that unhedged products are the better choice.

If you want to retire at a specific age, how long and how much investment should you make? I conducted a planning simulation to receive an average pension based on age and average annual wage in Korea. The simulation was conducted using the Portfolio Visualizer, as described in the previous post. First, the investment conditions were as follows:

https://www.portfoliovisualizer.com/monte-carlo-simulation

• Starting Age: 25 years old
• Portfolio Type : Portfolio Assets SPY(S&P 500), ONEQ (NASDAQ Composite) 50:50
• Initial Amount : 1 (since it must be greater than 0)
• Contribution Frequency : Monthly
• Tax Treatment : Pre-tax
• Simulation Model : Historical returns
• Use Full History : Yes
• Inflation Model : Historical inflation
• Rebalancing: None

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The monthly investment amounts needed to secure an average pension for each retirement age and the corresponding retirement point are presented in the table (50th percentile average values).

Retirement Age	Average Annual Earned Income (Million KRW)	Investing Period (Year)	Monthly Investment (10k KRW)	Total Principle (Million KRW)	CAGR (Norminal)	Appraised Value (Billion KRW)		Perpetual Withdrawal Rate	Annual Withdraw (Million KRW, PV)
						Norminal	PV
40	56.4	15	260	468	9.73%	1.25	0.85	6.66%	57.1
45	58.1	20	165	297	9.87%	1.48	0.90	6.63%	59.4
50	57.7	25	105	189	9.74%	1.66	0.89	6.53%	58.0
55	52.6	30	65	117	9.69%	1.73	0.81	6.46%	52.5
60	37.9	35	32	57.6	9.70%	1.42	0.59	6.49%	38.2

* Average Annual Earned Income Source: Ministry of Employment and Labor 2022

Observations from the simulation are as follows:

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• Looking at CAGR nominal returns, volatility can be largely ignored after 10 years, and most returns exhibit a robust upward trend.
• The adage that time is a crucial factor for pension investment still holds true. While there isn’t a significant difference in average wages between ages 40-55, the cumulative principal decreases significantly with a longer investment period. Pension investments emphasize the importance of starting as young as possible.
• Considering the tax deduction limit of 9 million KRW per year (monthly 750,000 KRW), a consistent investment for nearly 30 years seems to be the most effective approach to achieving both tax savings and pension investment success.

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In my case, as I started investing in my mid-30s and have a relatively short investment horizon, I’m trying to increase the monthly investment amount to compensate. For university students interested in investing, especially those in their early careers, I hope they establish a pension investment system as soon as possible, so that by the time they reach 50, they can retire with assets exceeding 1 billion KRW

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It was mentioned that pension investments should start as young as possible. If this were the case from birth, what would the outcome look like? The investment conditions are as follows:

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• Starting Age: 0 years old
• Portfolio Type: Portfolio Assets SPY (S&P 500), ONEQ (NASDAQ Composite) 50:50
• Initial Amount: 1 (since it must be greater than 0)
• Contribution Frequency: Monthly
• Tax Treatment: Pre-tax
• Simulation Model: Historical returns
• Use Full History: Yes
• Inflation Model: Historical inflation
• Rebalancing: None

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First, we assume that at age 0, the investment is made through a gift from parents to their child, as minors cannot invest directly. The current minor child gift limit in Korea is as follows:

Age	Gift Limit (Million KRW)
0-9	20
10-19	20
20-29	50
30~	50

Assuming a total gift of 40 million KRW by age 19, when the child reaches 30, the results are as follows:

–	Investing Period (Year)	Monthly Investment (10k KRW)	Total Principle (Million KRW)	CAGR (Nominal)	Appraised Value (Million KRW)
					Nominal	PV
Investment Period (0-19)	20	16.7	40.1	9.74%	150	90
Gliding (20-29)	10	–	–		377	180

The total investment amount is 40 million KRW and the evaluation amount is 4.50 times the initial amount in present value terms.

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Assuming a total gift of 90 million KRW by age 29, when the child reaches 30, the results are as follows:

–	Investing Period (Year)	Monthly Investment (10k KRW)	Total Principle (Million KRW)	CAGR (Norminal)	Appraised Value (Million KRW)
					Nominal	PV
Investment Period (0-19)	20	16.7	40.1	9.74%	150	90
Investment Period (20-29)	10	41.7	50.0		484	256

Investment Period (0-19)

The total investment amount is 90 million KRW and the evaluation amount is 2.84 times the initial amount in present value terms.

At age 30, a sum of approximately 180-250 million KRW would be accumulated. This amount could be used by the child for marriage, business, or other endeavors. Of course, if the pension investment amount is not withdrawn and continues to be invested, how would it look? Even without checking, it’s safe to say that it would grow exponentially. However, let’s verify the data once more.

구분	Investing Period (Year)	Monthly Investment (10k KRW)	Total Principle (Million KRW)	CAGR (Norminal)	Appraised Value (Million KRW)
					Nominal	PV
Investment Period (0-19)	20	16.7	40.1	9.74%	150	90
Gliding (20-49)	30	–	–		2,421	685

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The growth rate is exceptional. The conclusion is that there is no investment instrument that can beat the power of compounded returns over time. If parents establish such a system and then their children continue to build a pension system for their offspring, wouldn’t it lead to the perpetuation of wealth?

Our question is as follows: If we invest a fixed amount each year in a pension fund or an IRP account and continue contributing until retirement, how much will we have accumulated, and how much annual living expenses will we be able to cover? In this regard, we would like to introduce a useful simulation tool.

https://www.portfoliovisualizer.com/monte-carlo-simulation

The basic concept involves considering historical returns, volatility, and other factors related to U.S. stocks, and showcasing backtesting results based on specific investment conditions. This tool also offers Monte Carlo simulation capabilities, allowing us to explore future scenarios. I’m primarily investing in S&P 500 and Nasdaq 100 through a pension account. Thus, for this simulation, we have considered a 50:50 investment ratio in SPDR S&P 500 ETF (SPY) and Fidelity Nasdaq Composite ETF (ONEQ). While Nasdaq QQQ has a larger scale and is more suitable for reference, it’s important to note that the QQQ data used in the simulation is available from the year 2000 onwards. Since the year 2000 experienced the tech bubble and the index was exceptionally high, I thought we would be better to use the data starting point to the year 2004 which is ONEQ. As a result, the Nasdaq average returns would be what we are familiar with.

*Unit: The amounts are in dollars, but for your convenience, you can understand them in tens of thousands of Korean won.

• Portfolio Type: Choose Ticker, and in the Portfolio Assets section, select SPY and ONEQ.
• Initial Amount: This is the initial contribution, and since it needs to be greater than 0, you can enter 1.
• Contribution Frequency: Monthly
• Contribution Amount: 750,000 KRW (9m KRW annually)
• Simulation Period in Years: 20 years
• Tax Treatment: Pre-tax
• Simulation Model: Historical returns
• Use Full History: Yes
• Inflation Model: Historical inflation
• Rebalancing: Not performed
• Others: The Withdraw simulation option is more important, so it’s used as default in the simulation.

After setting the parameters as described above and clicking “Run Simulation,” the following results will be displayed.



The percentile-based results are shown, assuming the average, and the major results for the 50th percentile are as follows:

• Nominal Returns CAGR: 9.79%
• Effective Returns CAGR (Considering Inflation): 7.07%
• Nominal Portfolio Value: 670 KRW
• Effective Portfolio Value (Present Value Basis): 410 KRW
• Safe Withdrawal Rate: 9.26%
• Sustainable Withdrawal Rate: 6.61%



Considering the current inflation rate after COVID-19 and applying historical CAGR returns, the 9.26% safe withdrawal rate seems quite high. If we set a reasonable withdrawal rate of around 6.0%, you could sustain an annual living expense of 24.6 million KRW by selling ETFs on a present value basis (at least until your passing). In good market years, you could withdraw a bit more, and in not-so-good years, you could withdraw slightly less to balance things out. Adding in other factors like national pension and public employee pension, you might expect to have an annual pension of around 40 million KRW.

Once again, a notable observation here is the difference in slope between the 1-10 year range and the 11-20 year range on the graph. Indeed, when it comes to pension investments, time is a powerful factor. If you were to extend that time series to 30 years, the difference in slope between the 1-20 year range and the 21-30 year range would also be significant. Warren Buffett has mentioned that a significant portion of his wealth was accumulated in the past 10-20 years. This doesn’t mean he invested particularly well in those years; rather, some of his investments were made 40-50 years ago, and their value has grown exponentially over time. This once again emphasizes that pension investments should ideally begin as early as possible.

The following graph is a simulation based on the investment conditions I’m currently using.

• Contribution Frequency: Monthly
• Contribution Amount: 3.16m KRW (38m KRW annually)
• Simulation Period in Years: 20 years
• Tax Treatment: Pre-tax
• Simulation Model: Historical returns
• Use Full History: Yes
• Inflation Model: Historical inflation
• Rebalancing: Not performed



• Nominal Portfolio Value: 2.81 billion KRW
• Effective Portfolio Value (Present Value Basis): 1.7 billion KRW



With a 6.0% withdrawal rate set, I could potentially expect an annual income of 100 million KRW (present value basis) plus national pension (at least until your passing). Since a 20-year investment horizon is required, it seems I will need to diligently save money until my mid-50s. If I had started at 25 years old… it’s truly, truly regrettable. To some extent, the only thing I can do to shorten the retirement horizon is to increase my contribution amount. Time is a precious factor when it comes to pension investments.