Germany has a well-established occupational pension system, but participation among employees is only about 50% overall, and in the significant SME segment only 30%
Germany’s pay-as-you-go state pension system is challenged by the demographic trends of an ageing society. The current financing structure is unsustainable. The Deutsche Bundesbank has pointed out three options in a study: first, increase contributions by employers and employees; second, increase of government subsidies which are currently 4% of GDP; third, reduce pensions or delay of the retirement age, which is currently 67 years.
Since there are tight limits for the first two options, the third option seems to be the most likely outcome. If this were to be the case, the occupational and private pensions would become even more essential to compensate for the expected shortfall in the state system.
Germany has a well-established occupational pension system, but participation among employees is only about 50% overall, and in the significant SME segment only 30%. The system is also quite complex and inflexible. Portability between employers exists only partially.
Return guarantees limit investment into higher-return assets; therefore, most of the allowed investments have been in ‘safer’ fixed-income products that have delivered negative real returns in recent years.
The so-called Riester-Rente, the government-sponsored private pension system introduced 20 years ago, has just around 15 million policies, indicating a participation rate of only 50%. In addition, assets under management have been stagnating in recent years and the system is suffering from extremely high fees as well as guarantees, again restricting higher-returning investments like equities and real assets.
Pension research internationally has shown that the majority of contributors prefer to choose from a small number of straightforward mass products and to delegate investment management completely to their respective provider. At the same time, an important minority of contributors prefer to have full investment control of their funds.
We propose to introduce two models for these two market segments. A government-owned platform of ‘mass products’ for occupational and private pensions would be set up following the example of Collectum, the platform for the ITP occupational pension system in Sweden.
The platform chooses the pension providers and their products through a tender procedure. It offers detailed and transparent information about the pension products, so that contributors can easily make an informed decision.
The platform also collects the premiums from the contributors and passes them on to the providers. This means providers do not have to deal with distribution and collection of premiums, and can concentrate on the investment management, pension reporting and pension pay-out. Collectum has enabled costs to be reduced to below 50bps pa of assets.
Additionally, the platform should provide both financial planning tools and broad financial knowledge in order to facilitate individual pension planning and to improve general financial literacy. Portability between employers should be offered without charge. Between providers, portability should be possible at a fair charge.
For the second segment of the population, those preferring to actively invest their funds, the authors propose to set up an alternative pension model along the lines of the Canadian Regulated Retirement Savings Plan (RRSP).
Within this system, each contributor has their own securities account with an online bank and chooses among a wide range of eligible investments. Payouts from this account are only allowed for pensions. Withdrawals for other purposes are taxed at a punitively high withholding tax rate.
We also propose to make the pension system equally accessible to everyone, so as not to exclude the self-employed, civil servants, or those in parental leave, for example, as is currently the case.
For all employees, the UK system of automatic enrolment is recommended. New employees are registered automatically for pension contribution unless they explicitly opt out. This instrument has led to a significant increase of participation in the UK.
The internationally common pension tax regime EET (contributions exempt, investment returns exempt, pensions taxed) should be applied in Germany. In the UK contributors can contribute up to their whole annual salary to a higher limit of £40.000 (€46,000) and roll their allowance over for a maximum of three years.
To limit government-sponsored investment, there is a lifetime allowance (LTA) for the total accumulated pension wealth of £1.07m. If a contributor has accumulated more than this LTA at the time of retirement, the pensions paid out from the excess amount are taxed at a higher rate. This system enables contributors to save more in years with high income, with the option to compensate for years of potentially lower or no income later. Such flexibility is necessary for increasingly dynamic modern working biographies.
Guarantees should be abolished
Interest rate or premium guarantees in the accumulation phase are currently included in practically all German pension products, resulting in an extremely high allocation to bonds with low returns in the past two decades. The authors propose to abolish these guarantees in order to enable more investments in higher-return asset classes like equities. It would also lead to a much lower requirement of solvency capital for the providers, which would in the end reduce costs for the contributors.
In a number of countries, attractive defined contribution pension systems are already in place. But many of these same systems have not solved the pay-out phase problem, which is that they often do not cater adequately for longevity risk.
Lifetime guaranteed pensions result in low investment returns in the pay-out phase. As a solution to this important dilemma, we propose annuity pools (or tontines/dynamic pension pools) to be offered on the state-owned pension platform.
Such pools provide a lifetime pension whose level is not guaranteed. In other words: individual longevity risk is insured within the collective, but the pensioners assume investment and collective longevity risk – the risk that life expectancy for the whole collective increases.
A very prominent example for an annuity pool is the College Retirement Equities Fund (CREF), managed by the Teachers Insurance and Annuity Association of America (TIAA), insuring 3.9 million teachers. CREF was set up in 1952 and is to a large extent invested in equities. The model was created at the time to protect retirees against inflation.
In Sweden, an annuity pool approach is used for the pay-out phase of the Premium Pension, the funded part of the state pension system. In Canada the National Institute on Ageing (NIA) is proposing annuity pools under the term of Dynamic Pension Pools as a solution for longevity risk of defined contribution systems.
Our reform proposals have the potential to increase the investment returns and subsequent pensions in Germany significantly, make access to the system fairer, modernise the tax treatment, and dramatically raise individual participation in the system.
CFA Society Germany, the largest association of investment professionals in Germany, has published a position paper proposing a reform of government-sponsored occupational and private pensions in Germany.