When the German Pension Law was established in 1974 the rules covered defined benefit (DB) plans only. As employers became more and more concerned about the financing risks of DB plans, especially final salary plans, the demand for defined contribution (DC)-type pension plans grew.
As a consequence, various concepts of hybrid plans were developed and finally codified in the German Pension Law in 1999. Nonetheless, UK- or US-type DC promises are still not possible. Two years later the basis for a German pension fund (Pensionsfonds) was established. This new pension fund (Pensionsfonds) has slightly more liberal investment restrictions than the other external financing vehicles in Germany (Pensionskasse, direct insurance).
According to German Pension Law, two types of pension promises with DC character can be distinguished: hybrid plans and defined contribution plans with guaranteed minimum benefits (DC).
Design and characteristics
Hybrid plans Within a hybrid plan the employer grants certain contributions (mostly depending on individual salary) that are transformed into guaranteed benefits. These benefits represent an employee’s legal entitlement. The transformation can be done on either an accumulative or actuarial basis.
Hybrid plans typically include all types of pension benefits (old age, disability, death). Benefits from a hybrid plan are either provided as pensions or as lump sums.
All existing (internal/external) financing instruments can be used for the provision of hybrid plan benefits, as follows:
q book reserve method
q support fund,
q pension fund (Pensionsfonds, Pensionskasse) and
q direct insurance
It is important to note that under all German financing vehicles employers are liable for the delivery of guaranteed benefits. Therefore, the risks related with hybrid plans, eg, longevity and investment risks should not be neglected. These risks can be avoided by choosing one of the external financing instruments mentioned above including the support fund, if fully reinsured.
Because of limited tax-free contributions (in 2005 about e4,300 a year) for Pensionsfonds, Pensionskasse and direct insurance, hybrid plans often need to be financed via the book reserve method or support funds.
Therefore, the book reserve method and to some degree the support fund inevitably have an accounting impact. From an accounting point of view hybrid plans are to be treated as DB plans.
DC with guaranteed minimum benefits
In 2002, a DC plan concept was implemented in German Pension Law for the first time. Contrary to UK-/US-type DC plans, a German DC plan requires the guarantee of minimum benefits. In principle, German DC plans require the provision of benefits in the amount of the accrued contributions plus interest earnings. According to German Pension Law, minimum benefits are defined as the total of contributions minus risk premiums, if any. Therefore, even a continuous contribution record may lead to an employer´s liability if there are negative investment returns.
Pension funds (Pensionskasse, Pensionsfonds) and direct insurances are admissible financing instruments for a German DC plan. The promised contributions are recognised in the profit and loss statement. An accounting risk for a liability may occur if the funding level falls below the minimum guaranteed benefits. DC plans can provide all types of benefits.
As of 2005, tax-free contributions will be limited to about e4,300 a year (that is, 4% of the Social Security Ceiling SSC plus e1,800 a year). Because of these tax restrictions DC plans are well suited to provide adequate benefits levels for employees with earnings in the range of the SSC (SSC 2004 = e61,800). For higher-paid employees, DC plans can only be
a component of a total benefits package.
As UK/US-type DC plans cannot be exactly mirrored in Germany, the closest type of plan design is a DC plan with guaranteed minimum benefits, which was first implemented in 2002. DB plan designs are still prevalent, but there is a strong trend towards hybrid plans. But so far there is no clear picture yet concerning the success of DC plans with guaranteed minimum benefits.
Kurt Hausner and Marc Oliver Heine are with Aon Jauch & Hübner Consulting, based in Munich
DB/DC: the choice
Pension benefits (annuities, lump sums, etc) can be provided under a defined benefit plan (DB) or a defined contribution plan (DC). Under a DC plan, an employer’s sole obligation is to provide the promised contributions. An employee’s benefit is the total of these contributions plus returns on investment. Thus, the employer excludes all investment risks and any actuarial risks, if applicable, so there is no employer liability left. As a result, the employee bears all these risks.
The cost of a defined contribution plan are determined by the contributions according to the plan formula. Employer contributions are charged as an expense in the income statement, and there is no balance sheet liability. Actuarial valuations are not required.
Any other form of a pension plan is to be classified as a DB plan. The benefits from a DB plan are typically determined by a formula based on service and final, average or career-average salary. Accounting for DB plans is complex and requires actuarial valuations according to local and/or international accounting standards.
The cost of a DB plan are determined actuarially as a (relatively) stable percentage of earnings.