The Pensionsfonds vehicle was created in to fund pension liabilities off balance sheet. Liam Kennedy assesses views on funding trends in German corporates
Small and mid-sized companies, the so-called Mittelstand, were the engine of West German post-war growth and still form the backbone of Germany’s export-oriented economy. These companies are often still in family ownership and frequently employ on-balance sheet pension liabilities, or book reserves.
On balance sheet financing methods were seen in the post-war period as an optimum method of financing so-called direct pension promises - Direktzusagen. After all, why invest in the capital markets for a 4% annual return when your company provides a return on equity of 20%?
But internal funding has fallen out of favour since the introduction of the IAS accounting standards, and IAS19 in particular, even though internal funding of direct promises continues under the HGB local funding standard.
The Pensionsfonds was created under the auspices of the 2001-02 Riester reforms, with the purpose of creating an internationally comparable pension funding vehicle that was also compatible with the EU’s occupational pension funds directive. Unlike the existing Pensionskasse, whose roots lie in the 19th century, prudent person investment rules apply to the Pensionsfonds - even if the proportion of equities is relatively low and despite the fact that it is difficult to invest in alternatives.
The vehicle was also an attempt to provide a full funding vehicle that would sit alongside the contractual trust arrangement (CTA) alternative. CTAs are on balance sheet trusts and were mainly created by multinationals using IAS accounting rules or with a foreign listing, to fund book reserve pension promises. The Pensionsfonds - unlike a CTA where the liability and the assets remain on the balance sheet - allows for the full financing of these liabilities in an off balance sheet structure.
“On the one hand companies came out of the recession at the beginning of this decade, started to earn money again and had in mind that in adverse market conditions, when you are finding it hard earning your operational money, a high pension liability adds to your problems,” notes Thomas Huth, director of pension solutions at DB Advisors. “The other driver for the market was to a certain extent IFRS and the effect on ratings on your financial position. We clearly saw a lot of interest in CTA structures from 2004-06.”
Pensionsfonds have been less successful in their third main purpose - the investment of tax-advantageous salary-sacrifice contributions for individual retirement saving under the auspices of the Riester reforms. And after a slow start Pensionsfonds’ assets are hardly spectacular at something like €2.2bn, according to BaFIN.
German pensions specialists note that the two funding methods - Pensionsfonds and CTAs - are in some ways complementary, and many corporates now use both a CTA and a Pensionsfonds. Some have even adopted a structure whereby a Pensionsfonds is held within a CTA, with the CTA as the legal owner. “What you can see is we learn a lot from the DAX companies,” says Matthias Pross, head of pensions at Allianz Global Investors. “They have established their own CTAs for past service but they use a Pensionsfonds, with some tax implications, for future service.”
Larger companies, such as Bosch and Siemens, have opted to create their own Pensionsfonds, and some industries, such as the metal and chemical sectors, have also established their own dedicated vehicles. Alongside this there are a variety of Pensionsfonds with a commercial sponsor, usually an insurance company, available on the market. Allianz, for example, offers both a Pensionsfonds and a group CTA structure.
Last year Munich-based insurer LV 1871 attracted attention with its decision to domicile its Pensionsfonds in Liechtenstein, which as a member of the European Economic Area has implemented the EU pension funds directive. While Liechtenstein made the headlines earlier this year for reasons to do with tax evasion, Martin Großmann, managing director of the LV 1871 Pensionsfonds, is convinced that the principality offers both a sound and an attractive regulatory regime.
Großmann also notes that the philosophy of the principality’s supervisory regime is to “foster but also to make demands”, and he believes that Liechtenstein has interpreted the pension fund directive in a manner that is closer to its true spirit.
“One of the problems we have in Germany is that our supervisory and legal culture in the insurance sector is very strongly rules based,” comments Großmann. “An example is where it says in paragraph 115 of the insurance law that a financing plan may take five years, or 10 with the permission of BaFIN. But no period is specified in the EU directive, which uses the phrase ‘in due time’. Whether five or 10 years is the appropriate period depends on the individual case.” The choice of domicile also offers distinct advantages when it comes to the coverage ratio, according to Großmann.
Allianz announced earlier this year that it would not opt for Liechtenstein as a domicile for its pension vehicles, although executives are guarded as to the exact reasons behind this decision. But both they and others are keen to play down the advantages of the principality as a Pensionsfonds domicile.
“If you have a German-regulated vehicle you can fund the assets in Liechtenstein but you do not have an advantage on the vehicle itself because it is still funded under German law,” says Pross. “So maybe you have an advantage on the asset side but the vehicle is regulated under German law, so tax law is the same and it is the same on employer and employee level.”
Investment practice varies, with versions of the Pensionsfonds that offer a typical 2.25% guarantee using a less aggressive asset allocation policy than the variants with the statutory minimum sum-of-contributions guarantee. The Pensionsfonds of Bosch is one of the largest in the market with some €800m in assets. From 2006, all active employer-financed entitlements and salary sacrifice contributions have been financed using the Pensionsfonds, which accounts for its high asset volume.
So with all of these options in mind, will German smaller and mid-size companies really opt to fund their on-balance sheet liabilities? Those who know best are those who are really on the road, talking to the owners and managers of Germany’s true Mittelstand. Hans Melchiors, a board member at Volksfuersorge, is one of them. He says that interest in funding pension liabilities often attracts lukewarm interest: “I am not sure that all smaller companies will take this route,” he says. “I have very often discussed this issue with owners of companies and many say: ‘the money belongs to us and we need it’.”
But he and others are keen to stress the risks of funding all your assets internally. “It is a question of the environment around you,” says Melchiors, referring to the changing world of employment. “One of the reasons that it will become more and more modern to put assets into outside funding is because employees do not stay in their position at one company for as long as they used to.”
As others executives stressed, companies also realise as pensions fall due that their ability to meet these payments is strongly dependent on prevailing economic winds: it will be harder to meet liabilities from free cash flow if they start to fall due during a recession. Current credit conditions might well mean that companies have less free cashflow with which to fund pensions, but conversely, banks are said to look upon internal pension funding in an increasingly favourable light.
In any case, a survey conducted by Allianz for a report scheduled for publication in July, is likely to shed more light on the matter.
So what of the prospects for the Pensionsfonds? “The Pensionsfonds has found a place and will continue find it further,” concludes Pross. “It is the only vehicle with which we have a chance to get out of underfunding using a strategic asset allocation that is intelligent and which matches liabilities. If you look at funding levels of pension reserves, I would say that 60% of German companies are underfunded. And if you want to catch up with this you cannot do this with a typical insurance product. You have to be brave enough with intelligent concepts and with LDI to get into a higher equity level and to catch up to a funding level of 80-90%.”
With €30m in assets, Großmann is pleased with the inflows since LV 1871 opened its Pensionsfonds for business early in 2007. “This is clearly more than we planned for at the beginning,” he says. “At the moment this is a growth market and I am optimistic. There is a tendency towards greater volumes.”