It may have taken almost 50 years, but Germany’s most significant pension reform since the creation of the state pension system in 1957 has come as something of a milestone in a market unused to significant change. With the ratification on 11 May 2001 in the German Bundesrat of the Riester pension reform bill – named after its sponsor labour minister Walter Riester – the government got the green light to introduce new vehicles for second- and third-pillar pensions in a bid to offset cuts in an unsustainable state pension system.
That the German government had set out on the path of privatising parts of its state system was nothing short of revolutionary.
The reforms, effective from 1 January this year, provide tax incentives and allowances to enable the workforce to build up funded pension benefits.
This dramatic shift toward an Anglo-Saxon method of financing pensions, with a nod in the direction of the pensions harmonisation endeavours of the European Union, was necessary, the government said, to bolster a social security system faced with some of the starkest demographics in Europe.
By the summer of 1999 the government was announcing preliminary details of its plans to reform the way Germans would provide for their retirement. The objectives included a stabilisation of contributions to social security and a reduction in the level of payouts from the country’s PAYG system.
The flip side to the legislation would be the support of funded occupational and private pension arrangements. This would see the introduction of quasi-defined contribution (DC) plans, albeit with an implicit capital guarantee to render the reform more palatable to a public that was being asked to replace state guarantees with products open to market vagaries.
The new legislation stipulated that, as of 2001, pensions would be indexed to gross wage growth and corrected for changes in contributions to state pension insurance and private pension plans.
In practice, this meant that pension benefits relative to net wages would be reduced to 20% until 2020 and then not exceed 22% until 2030.
This cut, the government said, would be achieved by reducing the average net pension from70% to 67% of final net salary.
Even this reduction was based on theoretical numbers. In reality, the state pension level was lower. The changes meant that, to reach past levels of pension cover, employees would have to work and contribute to the social security system for around 45 years.
To balance the reduction in state benefits, individuals would now be able to set aside an extra 1% of gross wages every two years – up to stipulated tax ceilings. The step increase of 0.5% every year would reach its peak of 4% of gross wages by 2008.
In addition, lower wage earners would be able to offset the state pension reduction by claiming government money transfers to the amount of €154/308 for single/married couples, plus €185 a year for every child.
This pay-off by the government to individual savings plans is expected to cost the government €10.6bn by 2008.
In all, the reforms mean that employees will eventually have the right to have 4% of salary paid before tax into a company or individual pension scheme.
Traditionally, German companies could offer four different occupational pension products to their workers, the Support fund (Unterstützungskasse), the direct promise/book reserve (Direktzusage/Pensionsrückstellung), direct insurance contracts (Direktversicherung) or the insurance oriented Pensionskasse.
The legislation added a new vehicle to the occupational list – the Pensionsfond – liberal in its investment horizon, but bound by the guarantee of invested capital under the new law. Under the new legislation, however, the government set about making clear the direction it wanted to see the pensions industry moving – away from the company balance sheet and towards funding.
The government was conscious of the fact that from 2005 German listed companies would have to comply with international accounting standards – under which book reserves must be classified as unfunded liabilities, with unfavourable consequences for company valuations. Accordingly, it set about favouring ‘off-balance-sheet’ products – direct insurance, Pensionskassen and Pensionsfonds – and weaning German corporations away from ‘on-balance-sheet’ provisions, such as the book reserve (internal) and support fund (external).
Under the reforms an employee’s new pension margin can only be invested in a new Pensionsfond, an existing Pensionskasse, a direct life insurance contract, or into a third-pillar individual plan.
Employers, for their part, are now obliged to offer one of the three occupational pension options. Employees who invest in the three company pension vehicles, dubbed ‘Riester products’ – Pensionsfonds, Pensionskassen or direct insurance – can claim the tax benefits/subsidies applicable under the new law.
Nevertheless, pension reform is never quite as simple as that – less so in Germany than in perhaps any other country.
Wholesale abandonment of the book reserve system was not on the cards – perhaps not surprisingly, given that it amounts to almost 60% of German corporate pension financing. Indeed, under the new law, tax-deductible book reserves can now be built up from the age of 28, as opposed to their previous kick-off age of 30.
Persuasion rather than coercion appears to be the mantra.
Another significant development under the new law is that the somewhat oppressive German vesting period system (which for some employees could mean a working life without the necessary work periods needed to claim pension rights) has also been reduced from 10 to five years. Similarly, the minimum age required to reach vesting has been reduced from 35 to 30 years.
While many in the market acknowledge that this will increase the cost of occupational pension provision, one certain benefit will be to aid labour mobility, with employees able to change jobs more easily. Furthermore, the change will also give companies more flexibility in pensions financing.
To complicate matters further, though, the German reforms ran into problems during the first six months of their existence. While the rules for the third-pillar private pensions industry were successfully introduced at the beginning of the year, those for the second pillar stalled.
The speed of the reform meant that the German government had overlooked a number of key issues in the second pillar that threatened to derail the new Pensionsfond vehicle. Under the legislation, members of Pensionsfonds were to be obliged to turn their savings into an annuity on retirement – unlike all other occupational vehicles, where employees can take 20% of their pot as a lump sum.
The oversight effectively gave the private pensions market a head start against the occupational sector.
However, since January only 2.2m Riester contracts have been signed out of a potential 30m eligible employees. More worrying still, some 400,000 of these 2.2m contracts have already been cancelled. The controversy surrounding the development of the occupational pensions market demanded action. Recommendations from unions and consumer associations that employees should defer making any pensions choice until changes were made to the law rendered the need for reform even more acute.
On 1 July, the government responded to its critics by announcing that the Pensionsfonds would receive parity with other occupational savings methods. Members would be allowed to take 20% of their pension in a lump sum at retirement. In addition, the government amended its capital guarantee rules with a decision to abolish the compulsory cover of contributions. On the latter point, lobbyists had successfully argued that, under the Riester legislation, companies were already obliged to join the Cologne-based Pensions Sicherungs Verein (PSV), a group providing insurance to cover employers in the event of insolvency.
The obligation meant that it was not necessary for the Pensionsfond to give its own guarantee, since the employer would always have an insurance safety-net for employee pensions.
The government may also have been swayed by figures from the investment industry revealing the cost of such guarantees to future pensioner incomes.
According to Fidelity Investments, the yield reduction on such guaranteed policies could have represented between 1% and 3% a year. Alongside the reduction of state benefits, the lobbyists argued, the reforms in their former state would not have been sufficient to avoid age-related poverty in the future.
The ABA, Germany’s occupational pension fund association, welcomed the changes announced by Riester. ABA managing director Klaus Stiefermann commented: “This new legislation is on the right track and the changes will make the pension funds more attractive than they used to be.”
With the ink dry on the latest reforms the market is now digesting the impact for both occupational and private plans.
Where will German employees invest their retirement capital? Who will be the winners and losers in the race to be the providers of choice in the pensions markets?
One thing is certain, the flow of assets into German pension plans will be substantial. Germany will not reach the degree of capitalisation seen in the UK or the Netherlands overnight, but expectations are that during the next decade hundreds of billions of euros in German pension assets will be injected into the national and international markets.
German insurance giant Allianz has predicted that the volume of company pension schemes in Germany will double in the next 10 years, from €330bn to €660bn in assets.
However, Allianz believes that only 20% of the new retirement plans will be Anglo-Saxon style pension funds, with the majority of the money set to flow toward more traditional insurance arrangements.
Certainly, with occupational pension provision effectively under insurance regulation, the country’s insurers appear well placed to pick up good business.
Many have already added new Pensionsfond and Pensionskassen arrangements to their product ranges to meet demand – many through joint ventures with local and foreign insurers and banks.
Similarly, the country’s savings banks have seen their opportunity, and are busy putting together packages of insurance contracts and savings funds.
One factor that will be critical for success though will be volume, given the relatively small amounts per person, per month that will be invested. High set-up and administration costs alongside low margins will demand the critical mass to ensure profitability within a reasonable timeframe.
Logic dictates that the likely winners will be large local providers with strong branding and distribution. Most observers believe foreign providers will only be successful if they can ally strong investment and administration competence with the distribution strength of local players.
Research by Commerzbank Securities (ComSec), has indicated the extent to which the reforms could begin to reshape the German insurance and banking industry as a whole. In a research paper, entitled German Pensions – Racing for a Bigger Prize, it points out that the cost of introducing new pension products was higher than for products of a similar nature, because insurance companies are obliged to do the research and development from scratch.
With reporting requirements for the new funds also far exceeding those of traditional German retirement vehicles, ComSec predicts that insurance companies will need a strong corporate distribution network in place for pension funds and group schemes and that the flexible nature of the new pension funds means that providers will have to invest heavily in updating or implementing new IT systems.
The research concludes: “Larger companies will be more able absorb the cost of expansion, whilst smaller players are more likely to begin outsourcing their administration. Moreover, the new market could also lead to a flurry of cooperation and mergers between small insurance companies to cope with the cost of expanding their IT systems and distribution networks.”
The Riester reforms then are justifying their ‘revolutionary’ tag, both in their impact on German pension provision and on the market as a whole. And it is a revolution that may not be over yet.
Many believe the government is aware that further changes to the pensions law, such as a raising of the retirement age, will be needed if Germany is to really solve its demographic problems.
Others point to flaws within the reforms such as the inability for unemployed workers or non-employed spouses to contribute to new pension schemes.
Inevitably change on such a huge scale will leave room for improvement and re-evaluation.
But it is unlikely that any western European nation will take a larger step than Germany down the road of pension reform.