Some of the German corporate pension promises have a very long history and were put in place even before Bismarck started the social security system. At that time, it was absolutely rational for employers to offer long-term incentives like pension payments after retirement as the employee-turnover-ratios were ranging between 50% and 100% per year at the boom times of industrialisation and formation expenses for the new hires were exploding – a complete different kind of situation to what we have today with more than 4m people unemployed in Germany.
It became a tradition that a ‘good employer’ would have to offer some form of pension promise as part of the total compensation package. After the war, the German industry needed to preserve cash for operating and investing purposes and thus started the build-up of book reserves for pension liabilities (Direktzusage) – without corresponding funding
In course of the ‘economic miracle’, this convenient creation of internal financing became the dominant avenue for second pillar pensions , representing roughly two-thirds of the estimated total of €350bn in corporate pensions. One-quarter is organised in pension funds (Pensionskassen) – for the remainder, companies use direct insurance (Direktversicherung) or support funds (Unterstützungskassen).
Most of the time, the entire German pension landscape consisted of defined benefit (DB) schemes. Until today, German pension law has no provisions for pure defined contribution (DC) schemes. Only recently, some forms of hybrid DC schemes have evolved – at least, however, with guaranteed minimum interest or money-back floors.

Liability challenge
Not only in Germany (but especially here), the dynamics of pension liabilities have been underestimated for a long time. Book-value accounting at fixed rates, long ignored trends in longevity, thoughtless pension treatment in merger and acquisition activity, unfavourable company-specific demographics or the typical link of pensions to final pay, made pension liabilities develop into a timebomb. Sloppy and overly generous granting of pensions (‘funny money’ sometime in the future) has completed this picture.
For example, companies like Mannesmann have turned themselves from a steel pipe producer into a telecom servicing company – with significant early retirements. Conglomerates tended to buy companies (including all pensioners) and float other parts of the business (without pensioners). Therefore, the typical split of pension liabilities between active and passive employees in this transforming economy arrived at a ratio of 1:2. With jobs nowadays being created abroad rather than in Germany, this trend is even set to worsen.
A real wake-up-call hit the whole industry with the advent and application of US GAAP or IFRS accounting. Suddenly, this funny money sometime in the future had to be marked to market at (much lower) current discount rates, future accumulations causing pension liabilities to increase by 25% or more depending on the underlying population. Ever since these shocking eye-openers, nothing is as it was in corporate Germany.
Today, full transparency is key and there are no taboos any more when changing the design structures of pension schemes – typically shifting financial risks away from the employers over to the employees and to cut short on the longevity effects. For sure, all of the above issues will be addressed in today’s negotiations with the works councils. But the sins of the past have a long life due to the underpinning of past promises (Bestandsschutz/Wertgleichheit) when closing old schemes and opening new ones.
The absence of pure DC schemes has made employers look for other creative solutions. When using the still incomplete environment of the newly developed pension fund (Pensionsfonds) like Bosch, Deutsche Post and Deutsche Telekom, a money-back guarantee is as close as one can get to DC under the bAV-regime. A recent poll among big German employers has unveiled a growing preference for less mandatory company pensions (Versorgung) in favour of slightly higher salaries, allowing the employees to set aside more voluntary private pensions (Vorsorge) in form of deferred compensation.
A complete different regime represents the legal framework for long-term work hour flexibility (Flexi-Gesetz) offering employees a savings account for overtime (Zeit-Wert-Papier) – convertible in cash equivalent.
This cash equivalent can voluntarily be increased by additional deferred compensation transfers and be invested on a pre-tax basis comparable to a pure DC scheme without any risk for employers like Volkswagen. The resulting cash balance can be used for lump sum or annuity payments – or even for early retirement when calculated back from cash into time.

Funding challenge
During the past three years of turbulence and re-evaluations in the capital markets, most funded pension plans (FPPs) have been hit hard by eroding net asset valuation in combination with much higher pension liabilities due to the application of Anglo-Saxon valuation methods resulting in significant funding gaps. Notably in the US, some under-fundings even were as high as the total market capitalisation of a sponsor such as Ford.
Under US GAAP 89 or IFRS 19 ‘pension accounting’ was also introduced in Germany, comprising the calculation of expected return on plan assets and the use of a smoothening mechanism within a 10% corridor once a company had decided to fund its pension liabilities in a segregated and irrevocable way. These are important features as all chief financial officers like to avoid P&L-surprises from valuation swings of fairly volatile pension assets.
The financial wake-up call came from the rating agencies, which basically decided to treat unfunded pension liabilities finally as plain debt. This shift in analysis led to higher leverage ratios, some rating downgrades and even a black list of companies with high amounts of un-funded pension liabilities – the famous German book reserves without corresponding pension assets. Companies like Linde, Deutsche Post and ThyssenKrupp tried to challenge the agencies’ verdict with an elaborate study without much success.
Some other companies, however, such as Siemens and DaimlerChrysler, have been cash rich for a long time, and have started earmarking certain liquid assets as pension assets on their balance sheets. But investing in Spezialfonds became transparent, and the ‘slicing’ of a balance sheet into operating, financial and pension slices was not good enough for pension accounting as these funding methods were not irrevocable. It needs some courage to lock away the cash labelled ‘war chest’ before.
The Pensionsfonds had been designed to become the off-balance sheet FPP of choice for the transfer of existing on-balance sheet pension assets and liabilities. But if sponsors want to
avoid asking for the consent of all active employees and most pensioners, a contractual trust arrangement (CTA) appears to be the second best alternative – in absence of the best.
Meanwhile, providers of asset management products have started to develop group CTAs - trust platforms for many companies - a pension house with separate rooms. This could also be a vision for a European pension fund, although CTAs don’t qualify for it.

Risk management challenge
The tasks for German employers with unfunded pension reserves are diverse and complex. A number of things need to be addressed simultaneously as there are very many risk drivers in the pension value chain to be taken care of. Change-over from DB to DC is widespread.
Planning for step-funding of FPPs has begun almost everywhere and getting used to integral valuation of assets and liabilities according to IFRS still needs some experience. Basis for a long-term strategic asset allocation being a frictionless
asset liability modelling tool
(ALM) has been acknowledged.
Some more thoughts on pension governance are necessary. Laws like Sarbanes-Oxley Act, asking
for stringent procedures and controls, will enforce more due diligence, more drill-down and more group-wide harmonisation of key parameters.
Under conditions of yawning funding gaps, the pension
pendulum has almost entirely swung into the finance departments. Treasurers and short-term risk managers have taken the
lead in an attempt to safeguard the companies’ financial statements from virtually every risk involved in pensions.
Three issues can shed some water into this wine: firstly, DC-schemes have not seen their acid-test as yet; secondly, pensions or life insurance business is not short-term by nature, and thirdly, if the granting of pensions is not seen in the HR-context of attracting and keeping the best talents, what is the purpose?
Peter Scherkamp runs consulting firm Scherkamp & Partners (www.scherkamp.net)

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