Norman Dreger reviews Germany's position in the Melbourne Mercer Global Pension index and outlines areas for improvement

Germany's pension system is quite different as compared with the pension systems seen in much of the rest of the world, in particular in Anglo-Saxon countries. One of the largest differences is with regard to the funding of pension benefits. Here, the most common approach is internally by means of direct benefit promises. For pensions granted in this manner, a company would establish tax-deductible book reserves in its accounts in respect of the benefits that have accrued to date. In the case of internal financing in Germany, there is no requirement to set aside assets to pre-fund benefits. However, some companies chose to do so, on a voluntary basis.

Direct benefit promises are protected against company insolvency through mandatory pension insolvency insurance, provided by an organisation known as the PSVaG. All companies in Germany and Luxembourg that offer occupational pension benefits in this manner are required to pay premiums to the PSVaG.

This system consisting of unfunded pension plans, combined with compulsory mandatory pension insolvency insurance to provide benefit security, is clearly a radically different approach to pension provision as compared with the pre-funding approach what is typically seen in the Anglo-Saxon world.

Such differences make it challenging to compare Germany's pension system to the systems in other countries.

Melbourne Mercer index
Mercer recently published an update to the Melbourne Mercer Global Pension index, a study produced by Mercer for the Australian Centre for Financial Services which compares retirement income systems around the world and ranks them based on their adequacy, sustainability and integrity. In the latest version of the index, the study was expanded to cover 14 countries, with the addition of Brazil, France and Switzerland.
Germany was ranked twelfth with an index value of 54.0 in 2010, which equates to a C-grade classification. This ranking should be interpreted to mean that while there are clearly positive features in the Germany pension system, there is certainly room for improvement.

The index uses a number of objective criteria to compare retirement programmes in various countries based on three broad criteria: adequacy (are the benefits typically provided sufficient); sustainability, which examines the long-term robustness of the system in light of demographic changes; and integrity, which looks at the level of robustness in the system with regard to regulation and governance, protection for members and costs.

Scores are granted under each of these three sub-indices, which are then weighted and brought together to result in a total score. A ranking from A to E is given, with A being the highest, and E being the lowest.

The Melbourne Mercer Global Pension index set expectations quite high, which meant that as a result, none of the 14 countries analysed received an A ranking. Germany received a C ranking, along with Brazil, Chile, France, Singapore, the UK and the US. So although Germany did not receive a top ranking, the same ranking was also received by a number of other large developed industrial nations.

In earlier versions of the Melbourne Mercer Global Pension index, the concern was raised that the unique German situation was not fully reflected in the index scoring, in particular for the integrity index, which did not appear to fully reflect the benefit security provided through the comprehensive mandatory pension insolvency coverage. In the latest version of the index, however, the concerns regarding the approach to evaluating Germany have largely been resolved.

Areas for improvement
The German pension system is quite robust: there are broad based first pillar social security benefits, savings levels are high and company pension benefits are common. However, there is room for improvement in the system, and in particular, there are a couple of specific measures that Germany could undertake to improve the health of its pension system:

• Social security: German social security retirement benefits are based entirely on a pay-as-you go approach. This means that current workers make contributions to pay for the pensions of those people who are currently in retirement. While this approach works generally quite well if the population is growing or at least relatively stable, there are clear problems associated with this in environments where the population is ageing. As the size of the active workforce decreases, while the pensioner population increases, the result is a shrinking working population that has to bear ever increasing pension costs. As a result, social security contributions would likely have to be gradually increased, and/or the pension benefits decreased. This could continue in perpetuity or at least until the negative demographic developments in Germany reverse.

In order to mitigate these demographic changes, the social security system could be modified to include an element of pre-funding. While this would mean an increase in the contributions required now, it may be possible to structure the system in such a way so that contribution and benefit levels would be expected to remain relatively stable in the future. This would help ensure that the German social security retirement system remains sustainable for generations to come.

• Form of benefit payment: A further issue raise by the index is around the form of benefit payment, in particular the payment of company pension benefits as annuities versus lump sums. Although historically most pension benefits were paid out as annuities in Germany, there are few requirements which mandate that benefits be paid out in this manner. In fact, there is a growing trend in new pension plan design to pay a larger percentage of pension benefits as lump-sums or in instalments than was done in the past. While this may be beneficial to companies, as the longevity and investment risks associated with the pension plan would be reduced, this places additional risks on plan beneficiaries. However, individual plan beneficiaries are probably not in a good position to mitigate such risks, for instance the risk that they outlive their savings; this is something that is likely better dealt with in a collective structure. In response to this trend, the government could consider mandating that a portion of corporate pension benefits would always need to be provided in the form of an annuity.

• Other issues: Other points that were criticised were the low level of workforce participation for older workers, low minimum pensions for low earners, and the lack of mandatory communication to beneficiaries regarding their pension benefits. If the government were to take steps to deal with these issues, it would almost certainly improve the health of the German pension system, and thus also the rating received in the Melbourne index.

Germany's ranking in the Melbourne Mercer Global Pension index indicates that, while the system has some positive features, there is clearly room for improvement. It will be up to legislators and other interested parties to ensure that the system remains sound, and that these deficiencies are addressed.

Norman Dreger is an actuary and a principal at Mercer in Germany