Taking out life insurance for employees (so-called ‘direct insurance’) is one of the four traditional ways of financing occupational pension schemes in Germany. A direct insurance policy may be employer-sponsored or contributions may be paid out of the employee’s salary (Entgeltumwandlung). Mixed financing is also possible.
Direct insurance has become increasingly common over the last two decades (see figure). Its share of the assets accumulated in occupational pension schemes (13% in 2000) has been growing steadily. One reason for this is that book reserve schemes, which make up the largest part of pension scheme assets (59% in 2000), are becoming less and less popular because of the risks they constitute for employers and their effect on balance sheets.
Direct insurance offers many advantages to both employers and employees.
A wide variety of direct insurance products is available in the German market. Benefits may be paid out in the form of a lump sum at retirement, old age pensions, occupational disability pensions and/or death benefits. Insurance companies offer direct insurance with different investment strategies (unit-linked, with-profits or a mixture of both). Thus, it is possible to take into account an employee’s indi-vidual circumstances (marital status, earnings, attitude to risk) in the choice of contract. Other types of pension schemes in contrast typically offer uniform benefits.
Employers that choose the direct insurance vehicle need hardly any expertise in the area of occupational pensions. The administration of the scheme is mainly carried out by the insurance company and almost all risks are borne by the insurer. This makes direct insurance the instrument of choice for most small businesses and also many medium-sized companies.
If an employee changes employer, the policy can be transferred with him or her, or the employee may become the policyholder and pay the contributions him/herself.
Contributions are treated favourably under tax law and are in many cases exempt from social security charges.
The German pension reform of 2001 has fundamentally changed the legal framework of occupational pension schemes, with substantial implications for all types of funding. The aim of the reform was to increase occupational and private pension provision to compensate for the reduction in benefit levels in the state pension system.
The most important provision of the Pension Reform Act from an occupational pensions perspective is the so-called Entgeltumwandlungsanspruch. From 2002 all employees have a legal right to demand that part of their salary (up to 4% of the earnings ceiling of the social security system, e2,160 in 2001) is paid into an occupational pension scheme.
In principle, any one of the available types of occupational pension schemes may be selected for this purpose: the four traditional models (book reserve schemes, support funds, Pensionskassen or direct insurance) or the Pensionsfonds, a new type of financing that was introduced by the Pension Reform Act.
However, the use of book reserve schemes and support funds for Entgeltumwandlung necessitates an agreement between employer and employee. Pensionsfonds and Pensionskassen, on the other hand, can be unilaterally chosen by the employer; the employee is not entitled to ask for any other plan.
If the employer does not offer a Pensionsfonds or Pensionskassen plan the employee has the right to demand that the employer takes out direct insurance for him or her. This means that direct insurance has become the solution of last resort if the employer has not set up one of these plans and there is no agreed book reserve scheme or support funds scheme. It is widely expected that many small and medium-sized businesses will end up with direct insurance schemes because they are familiar with this vehicle and it requires very little effort on their part.

The new right to a company pension should vastly increase the coverage of occupational pensions, which is comparably low in Germany. Conservative estimates suggest that the assets accumulated in occupational pension schemes will double over a 10-year period. All types of financing will profit from the increase in occupational savings, though it is believed that Pensionsfonds, Pensionskassen and direct insurance will gain market share from book reserve schemes and support funds. Still, there is great uncertainty about the future split between these types of occupational pensions and there is an ongoing discussion on the advantages and disadvantages of the different models under the new legal framework.
One important aspect in this discussion is the very different tax treatment of the various kinds of tax-favoured savings. In addition to the existing tax-incentives for company pension schemes substantial new tax advantages were implemented for both private and occupational savings by the Pension Re-form Act.
Firstly, the Riester incentive, consisting of state grants and tax deductions, is being introduced gradually between 2002 and 2008. It can be used for eligible private pension plans or for eligible occupational pensions in the form of direct insurance, Pensionsfonds or Pensionskassen (book reserve schemes and support funds are not permitted, but their contributions are tax-exempt in any case).
However, using the Riester incentive for occupational savings has some disadvantages, the major ones being that it is not possible to use the accumulated capital to purchase an owner-occupied home and that Riester contributions are subject to social security charges. For this reason, providers advise consumers to use private plans to take advantage of the Riester incentive and convert their salary into other tax-advantageous forms of company pension, which are also free of social security charges until 2008.
Secondly, in addition to (and independently of) the Riester incentive a new tax advantage for Pensionfonds and Pensionskassen was introduced in 2002: deferred taxation of contributions such schemes of up to 4% of the social security ceiling. Direct insurance is not included in this provision. Many experts view this omission as a big disadvantage for the direct insurance vehicle because deferred taxation can be very favourable.
However, this does not take into consideration that employees can still choose the traditional direct insurance tax incentive which in many cases may be even more favourable. Direct insurance contributions of up to e1,752 a year are taxed at a reduced rate (about 22%) which is very attractive for many employees because the regular tax rate is often much higher (up to 48.5%). If this form of taxation is chosen, benefits are tax-free if paid out in form of a lump sum and only partly taxed in case of an annuity. In contrast, benefits are fully taxed when contributions are tax-exempt or tax-deductible.
Employers are obliged to establish a company pension scheme in 2002. This means that there are only a few months left to decide on the type of scheme. In this respect, direct insurance has a competitive advantage over Pensionsfonds and Pensionskassen. It is an established vehicle with many different products already available and most of the legal questions settled.
Pensionsfonds, on the other hand, are being held back by controversy over a number of legal provisions and their sluggish approval of by the supervisory authority. Up to the end of June, only 10 Pensionsfonds and four new Pensionskassen have received regulatory approval, almost all of them in May and June. Therefore the market for these schemes has just started to evolve and only a few products are available.
Anja Theis is with product management at Deutscher Herold Lebenversicherung in Bonn