The German pension reform has implications for all three pension pillars: state, occupational and personal. The political objectives of the German pension reform were to:
q stablilise contributions to the social security system;
q avoid age-related poverty;
q reduce the level of the PAYG financing social security pensions;
q support funded occupational pensions by introducing pension funds (Pensionsfonds);
q support funded private pensions by introducing third-pillar pensions (Riester pension);
q introduce quasi-defined contribution pensions (DC with an implied capital guarantee), and
q support Germany as a financial centre.
The objective of changing social security pensions is to obtain a stable level of social security contributions, which are to stay below 20% of gross salary until 2020 and below 22 % until 2030. This should be achieved by reducing the net replacement ratio (net state pension to net active earnings prior to retirement), from 70% to 67%. This reduction of the state pension is a theoretical number. In reality, the state pension level is lower. Not many pensioners will reach such a high level of pension, since the calculation assumes people have worked and contributed into the social security system for 45 years based on average earnings. The calculation is also skewed because of people benefiting from other state benefits such as disability and early retirement pensions.
The Riester pension is a new voluntary third-pillar vehicle with the aim to subsidise the reductions in the social security pension. It provides tax incentives and allowances. Savings products qualify as Riester pensions as long as they satisfy certain conditions, including a capital guarantee of the contributions by retirement age (earliest age 60) and an annuity pay-out instead of a lump sum. The underlying capital guarantee reduces the expected return and makes it difficult for providers, who focus only on asset management. Since January 2002, only 2m Riester contracts have been signed. Furthermore, some 400,000 of these 2m contracts have already been cancelled. Hence, the Riester pension can be seen as a failure as it was introduced for 30m eligible employees.
A central aspect of the occupational pension reform was the introduction of a new funding vehicle and the reduction of the vesting period. The vesting period was reduced from 10 to five years and the minimum age for vesting from 35 to 30 years. If employees contribute directly to the occupational pension system, the benefits become legally vested immediately. The new vehicle is called Pensionsfonds. It is the fifth funding method for occupational pensions. Other changes include the introduction of quasi- defined contribution pensions, insolvency, pension indexation and pension tariff agreements for deferred compensation schemes. Since 1 January, employees can demand to participate in deferred compensation. If tariff agreements are in place to rule the compensation, it will be necessary that corresponding collective agreements allow this (Tarifvorbehalt).
The direct promise financed via book reserves is the prevalent financing method for occupational pensions in Germany. The plan sponsor is the legal carrier and covers both the biometric risks (death, disability and longevity) and the investment risk. The beneficiaries have a legal claim to their pensions, once they are vested. The underlying pension liabilities are recognised in the plan sponsor’s balance sheet as book reserves. This funding method does not require any investment guidelines and formal reporting to the insurance and investment supervisory body BAFin. However, the plan sponsor has to pay risk premiums to the statutory insolence insurance body PSV to insure the case of insolvency.
A contractual trust agreement (CTA) is a particular way to finance a direct pension promise via book reserves, where pension assets are defined and ring-fenced. The defined pension assets are pledged to the beneficiaries. Under German accounting rules the pension liabilities are still on the balance sheet as book reserves, whereas under international accounting rules (IAS and FAS) the pension liabilities are off the balance sheet due to the trust arrangement. The CTA does not exist under a regulatory governance framework. This gives the employer free rein in designing the governance of the CTA, including the composition of the trustee body and the investment guidelines. Typically, bigger multinational companies have adopted the CTA model due to its recognition under US GAAP as plan assets. It is in the interest of these companies to adopt a worldwide accounting methodology that recognises plan assets.
The support fund represents the oldest form of company pension schemes with its origin in the middle of the 19th century. One or more employers can establish a support fund as legal carrier. Due to the legal definition of the support fund employees do not have a formal legal claim to the pension. This is to avoid the insurance and investment supervision. However, the support fund is at arm’s length to the plan sponsor, which has to substitute any claims if the support fund falls short of its obligations. Support funds are not regulated in their investments. They can even provide loans to the sponsoring company. Support funds have to pay risk premiums to the PSV.
The Pensionskasse is an independent legal entity. It is in fact a life insurance company, in most cases owned by the plan sponsor. It is regulated by the insurance act VAG and supervised by the BAFin. Beneficiaries have a legal claim to their pensions. The Pensionskasse has defined reporting guidelines and investment restrictions. There is no need to pay premiums to the PSV.
Direct insurance corresponds largely to normal private life insurance contracts and to the Pensionskasse. Here, however, the employer is the policyholder and the insurance is provided by an independent third party. The beneficiary has a direct legal claim against the third-party insurance company. Smaller companies prefer the direct insurance route as a funding method for occupational pensions, since it does not require much administration and reporting by of the plan sponsor. Usually, the employer does not have influence on the underlying investment strategy. There is no need for the plan sponsor to pay premiums to the PSV.
The Pensionsfonds is the new pension vehicle and the fifth funding method for company pensions. It finances the occupational pension provided by one or several employers to their employees. It can insure biometric risks and it grants a legal claim to the beneficiaries. The benefits of the pension promises must be paid as annuities. However, legislative changes that came into force in July will enable beneficiaries to take up to 20% of their savings in cash at retirement. The Pensionsfonds is regulated by the insurance act VAG and supervised by the BAFin. It has defined reporting guidelines and investment restrictions, which focus on qualitative rather than quantitative restrictions. The Pensionsfonds has to pay premiums to the PSV. It is possible to transfer existing book reserves and support funds to the new Pensionsfonds vehicle.
Historically, the universal banks in Germany have offered asset management, brokerage and custody under one roof. This however, has lead to some conflict of interest in how best to service clients. Nowadays, more clients require a specialised supplier of these services. The split has led to the appointment of global custodians, the reduction in the number of relationships with KAGs as well as reducing the number of underlying Spezialfonds. The main arguments are communication and reporting improvements, as well as tax and accounting advantages. In that sense, the ideal structure for pension assets could consist of one (master-) KAG and only a small number of Spezialfonds. Each of these funds could have several segments to be managed or advised by various asset managers (multi-adviser concept). Rebalancing, set-up of new asset classes and changing of advisers within that structure can be implemented without realising gains or hidden reserves.
A flexible pension vehicle is required to implement such an investment structure. In terms of the pension vehicles, the Pensionsfonds structure has qualitative investment guidelines and does not need to follow strict quantitative restrictions. Pensionskasse or direct insurance on the other hand are still limited – for example, with their equity exposure due to quantitative rules. The book reserved CTA and the support fund are most flexible with no investment restrictions and investment reporting guidelines. However, neither funding method can finance the new state-subsidised quasi-DC schemes. Furthermore, the support fund can only be fully funded if it uses reinsurance, which will restrict the investment flexibility due to the insurance supervision (see table).
The pension reform has not significantly improved the framework for managing pension assets as yet. Further reforms or changes of the reform are needed but it is encouraging to see that the process is already under way with the expected introduction of the 20% cash sum payments of Pensionsfonds.
Olaf John is Geschäftsführer at Fidelity Investment Services in Frankfurt and in charge of the institutional business of Fidelity Investments in Germany and Austria