As everybody knows, pension funds are now available in Germany. So, surely, contractually constructed arrangements are on the way out? Wrong. And the main reasons are that such contractual trust arrangements (CTAs) are more flexible, not subject to supervision by the Federal Financial Services Authority, more tax-efficient, allow free setting of the pace of funding by the sponsor and are not subject to any statutory investment restrictions whatsoever.
At the beginning of the 1990s German companies were increasingly searching for off-balance-sheet solutions for financing their pension schemes. At first, this held true for international employers employing book reserves, motivated primarily by the negative balance sheet impact of pure book reserves and by the desire to better match assets and the associated pension liabilities. Various forms of CTA were developed.
A CTA can best be described within the framework of a book reserved pension arrangement – that is, an arrangement that is not funded by explicitly earmarked assets but rather backed by the general assets held by the sponsoring company. If the plan sponsor now ring-fences certain company assets and, by establishing a contractual trust, effectively restricts their usage to providing for the corresponding pension liabilities, such assets qualify as plan assets under both US and international GAAP.
This has the advantage that after the ring-fencing has been established, the market value of these assets is netted-off against the book reserves accrued. This reduces the balance sheet position ‘unfunded accrued pension cost’ on the balance sheet, the sponsoring company’s key financial ratios improve and the shareholders can no longer criticise their management for unreasonable asset/liability risk management.
Book reserves continue to play the major role and are expected to continue to do so.
Changes in the Federal Tax Code allow existing plans financed by book reserves or by support funds to be transferred to a Pensionsfonds.
Before reading on, it should be borne in mind that trust law, as it exists in the British tradition, does not exist in many other countries, Germany being one of these. Hence the ‘C’ in ‘CTA’.
Even if we find more simple structures in practice, the most popular method of constructing a CTA is as follows. The first step is to establish a separate legal entity, the ‘pension trust’, typically an association with appropriate articles of association, and then a contractual agreement between this trust and the sponsoring company. This agreement will typically restrict the use of the assets in such a way so as to comply with the requirements of US or international accounting standards – that is, beyond insolvency. If this is not done with care, the assets may be construed to have become direct earnings of all beneficiaries, with unintended wage taxes becoming due. There are various advantages to establish a further legal entity, or ‘custodian’ and a second contract level between trust and custodian. Then the required liquidity, representing part or more of the companies’ obligation with respect to the pension scheme has to be transferred to the trust which then, if so constructed, transfers on the assets received to the custodian, which is then responsible for their investment. Clearly, the guidance the custodian receives should be documented in an agreement between trust and custodian. Included in this too should be the investment management principles.
Pensionsfonds generally bear advantages vis-à-vis CTAs in the following points:
q Vehicle for financing the ‘Riester Rente’: As mentioned above, CTAs are not permitted vehicles for financing retirement benefits intended to replace the shortfall created by the reduction in the level of social security retirement benefits, Germany’s equivalent of British stakeholder pensions. Permitted vehicles in the area of company pensions are the Pensionskasse, Pensionsfonds and direct insurance arrangements.
q Special circumstances: Under special circumstances, higher tax deductions can be claimed under a Pensionsfonds than under a CTA construction, such as when modest pension contributions are made to a fund on a sporadic basis (for example, subject to profitability of the sponsoring employer).
In the following aspects CTAs and Pensionsfonds are generally broadly equivalent to each other:
q Netting-off: As already mentioned, it is possible to net off the assets held in the CTA against the companies’ pension liabilities in the IAS/US–GAAP accounts. This generally leads to a better rating of the company by financial analysts. This is not only important for listed companies, since the repercussions of the new Basle Banking Accord (‘Basle II’) regarding solvency margins we expect mid-sized companies to increasingly establish external funding arrangements of their pension liabilities to reduce their cost of debt capital.
q Insolvency protection: Both the Pensionsfonds and the CTA are subject to mandatory membership in the Pensions-Sicherungs-Verein (PSV).
CTAs generally have advantages vis-à-vis Pensionsfonds in the following ways:
q Pace of funding: The sponsoring company is free in its decision to what extent the CTA is to be granted contributions since the tax deduction for the contributions is regulated by the rules governing the calculation of the book reserves. The Pensionsfonds will generally not be free in its funding requirement since it is required to submit a business plan for approval to the BAFin.
q Constructive income to the beneficiary: Contributions made to a Pensionsfonds in excess of 4% of the social security contribution ceiling are regarded as constructive income to the beneficiary. In other words, such contributions are subject to the personal marginal income tax of the individual concerned. In comparison, contributions made to a CTA are effectively not capped. This characteristic allows not only adequate funding of higher pension amounts but also enables such amounts to be effectively protected against insolvency of the sponsoring company, a side-effect that is typically high on the agenda of higher paid executives.
q Investment restrictions: Even though there are effectively no quantitative restrictions for Pensionsfonds, they are nevertheless subject to other restrictions in respect of type of investments, diversification rules and the requirement to justify their investment strategy towards the supervisory authority, BAFin. It can thus be concluded, since CTAs are not subject to such restriction, that the risk-return frontier is further reaching than for Pensionsfonds with the result that higher investment returns are – at least in theory – possible under a CTA construction.
q Administration costs: For larger entities the reporting requirements of a single-employer Pensionsfonds will be more extensive and therefore more costly to the sponsoring employer than a single-employer CTA. This should hold broadly true for smaller employers and corresponding multiple-employer entities. We expect multiple-employer CTAs to be established in the German market in the not too distant future.
Under the current and expected framework in Germany, the CTA is destined to continue to fill a leading role amongst the alternative instruments available for external funding of occupational pension schemes in Germany. In various fields it provides superior characteristics such as investment freedom, no supervisory authority, free determination of funding pace and allows an almost unlimited variety in plan designs.
Alf Gohdes and Bernd Haferstock are with consultants Buck Heissmann in Wiesbaden