Germany’s state benefits, as might be expected given the generosity of the system, are the dominant source of retirement income, particularly for those on middle and lower incomes. By contrast, private pension income forms a small part of the total retirement income and a relatively small share compared with many other countries. Our chart confirms this picture.
Retirement income from the state provides a substantial ‘annuity’ stream for many and consistent with this, private sector pension benefits have typically enjoyed wide discretion as to the form in which benefits are paid. Tax treatment has been a key influence on the form selected.
Most benefits emerging from arrangements associated with book reserves are understood to be taken in annuitised form, in that the income payments are made for life. This fits with the ‘EET’ tax treatment, providing tax relief on contributions and investment return, but with tax payable on benefits.
Recently, there has been a growth in deferred compensation schemes from which proceeds are paid either as a lump sum or over a limited period of time. This payout structure avoids the obligation to increase payments with indexation that arises if payments take the form of a lifetime annuity. Retirement benefits arising from ‘insurance’ vehicles whether direct insurance or Pensionskassen, which provide funded benefits through a mutual insurance vehicle, operated by one or more employers, were until the start of the year typically taken in lump sum form, reflecting the TEE tax treatment. However, all this has just begun to change.

Reforms in progress
Key elements of reform that will have a bearing on retirement income include:
q The reduction in state pension benefits resulting from the pension reforms introduced in 2001and increased exposure to tax and health insurance contributions. As of this year, the calculation of state pension benefit will also include a ‘sustainability’ factor which will further reduce pensions to the extent that numbers of pensioners grow faster than
numbers of active employees. There is also discussion about further raising the retirement age. Those wishing to maintain retirement income need to look for private sector solutions;
q The supplementary funded ‘Riester’ pensions, also introduced in the 2001 reforms, require retirement benefits to be taken largely (80%+) in income form, either as an annuity or as a mix of phased withdrawals (in early retirement) and annuity (late retirement). Tax treatment for Riester plans is EET and consequently phased withdrawals or annuity payments will be taxable;
q The Retirement Income Act which shifts taxation for Pensionskassen and direct insurance pension vehicles towards an EET model.
The introduction of the ‘Rürup Rente’, a deferred annuity with tax deductibility on contributions rising from 60% in 2005 to 100% in 2025) and the associated reduction in tax advantages for life assurance savings products, effective from the beginning of this year. The growth element of lump sum maturity payments from insurance policies will for contracts written after 1 January 2005 be taxed at least at 50% compared with zero previously.
It will be interesting to see whether consumers are willing to accept the constraints and requirements of the deferred annuity in order to obtain tax privileges or whether they will shift savings away from life assurance vehicles to investment/mutual funds now that there is less of a tax incentive to go down the traditional insurance savings route.
The reforms outlined above have the potential to create increased demand for annuities although the impact is likely to take many years to emerge.
The shift in risk bearing away from the state and towards individuals seems to be stimulating an interest in forms of retirement provision that extend beyond funded pensions, in particular into areas such as annuities to pay nursing home fees or for impaired lives, and equity release schemes.
The more affluent elderly and their need for retirement income is attracting attention from financial advisers. Supply side constraints on the
annuity market are likely to be much less than in say the UK over the next decade as:
q Volumes of annuity business are growing from a low base;
q Current reforms will not mature for many years;
q Annuities are written on a ‘with profits’ basis so providing a larger cushion against understating longevity or interest rate risk;
q Membership of the Euro-zone provides access to a very large pool of bond suppliers (although issuance is focused on shorter durations with less than 15% of eurobonds over 10 years in duration);
q The zone also offers access to a significant supply of fixed rate and securitised mortgages, which supplement bond supply.
However, the balance sheets of life companies are likely to come under increased pressure from new accounting and solvency requirements during the course of the next decade. Capital requirements are expected to increase and new mortality tables are expected to put upward pressure on pricing
and reserving for annuities. In addition from 2006, annuity rates are to
be unisex to comply with anticipated EU requirements. There has already been a shift towards the largest and strongest companies in the market shares of the Riester pension products and this trend may be expected to apply to annuity provision.
Reductions in state benefits are expected to emerge gradually and alternatives to make up the shortfall, whether under proposed new pension arrangements or private savings, to develop equally gradually. However, the pension and life insurance reforms do place a substantial emphasis on annuitised or phased withdrawal solutions.
This emphasis may well foster the development of a more substantial annuity market. Growth in retirement income business may also develop as intermediaries and advisers turn their attention towards opportunities in this market and away from traditional life assurance savings.
Mark Wadsworth is a partner at Watson Wyatt in the UK