Despite boasting the largest economy in Europe, the long-established and comprehensive social security system in Germany is beginning to creak and show its age. Although it is not alone in facing the problem of a greying population the German government faces a bigger problem than most, both in terms of the size of the problem, and the difficulty it faces in developing a sophisticated pension sector.
It is calculated that by 2020 around 30% of the population will be aged over 60; only Switzerland and Italy will have a bigger proportion. With pension payments in 1997 of around $300bn (e348bn), almost all coming from the state-sponsored pay-as-you-go system, alternative methods of funding are urgently sought. The gap between contributions and benefits will mean that rates of the latter are bound to fall.
The problem the government faces is that the state system is so entrenched in the nation’s cultural psyche that reform is unpopular and contrary to the conservative nature of successive German governments.
Nevertheless, there is a growing sense of crisis in the system, which has at last resulted in firm proposals from the government to encourage the second and third pillar provision, with some fiscal incentives. This follows a long campaign by the German Federation for Occupational Provision, Aba, and others, for the system to be modernised.
The statutory social security system, among the most comprehensive in the world, ensures workers maintain an adequate standard of living in retirement. All wage and salary earners are required to be part of the system, while the self-employed may join on a voluntary basis. Total contributions amount to around 40% of average salary, with just under a half of that relating to retirement, survivor and disability payments, which is split equally between employer and employee each contributing 9.75% of salary. The size of the pension depends on contributions, but the average pension after 45 years in the system is 70% of annual salary, one of the most generous in Europe.
It is not necessary to retire at 65 to be eligible for retirement benefits, and retirement may be delayed until 67, with a monthly bonus up to retirement payable at the rate of 0.5%.
This system is supported by a mandatory earnings related state scheme introduced in 1957, membership of which was made compulsory in 1968, for wage earners and salaried employees. This was later extended to the self-employed and housewives in 1972, although in their cases membership remained voluntary.
The second support to the system is provided occupational plans. The first plans were instigated over a century ago, and reforms to the state system have increased their popularity. Legislation passed in 1974 recognises four methods of funding:
q direct insurance, or funding outside the company. In this case benefits are purchased directly from an insurance company. In this case the employer’s contribution is fully tax- deductible as an operating cost of the company, but is treated as taxable income to the employee. Such policies are normally purchased by smaller companies, for higher paid employees, for whom they may also take over the tax liability, and pay at a smaller rate. Employees may also contribute to the funds. Supervision is provided by the German insurance supervisory law, and strict measures apply. For example, investment in equities is limited to 35%.
q secondly, a company may elect to provide via a special assurance company, the Pensionkasse. In this case, reserves are set aside in dedicated institutions or trusts. As in the case of insurance companies, employees may also contribute. Because of their nature, these funds are very strictly controlled under German law. The same principles of taxation apply as in the insurance example above.
q support funds, in which contributions are not treated as a taxable benefit for the employee and which are subject to much more liberal supervision. For example, it is possible to to invest the assets entirely in equity loans back to the supporting company. This means that funds that invest in this manner cannot be fully funded and must take out insolvency protection provision, which was introduced in the 1974 reforms and also applies to the final method of provision, via book reserves.
q Book reserves are built up in the companies’ balance sheets, are not subject to investment restriction, and need not appear as a separate pension asset in the companies’ balance sheets. This by far the most popular way of financing occupational schemes, despite the fact that employee contributions are not permitted.The employer’s contribution is tax-deductible, and although benefits are taxable income there are comprehensive incentives, which effectively make them tax-free.
By the end of the 1970s these schemes covered, on a voluntary basis, about 70% of all employees, providing around 10% to 15% of final income as benefit. Since that heyday, however, there has been a falling off of interest in the plans. This is worrying for the government, as any projected root and branch reform of the pension system will inevitably result in a fall in the value of the state pension, causing the pension gap to grow. It is clear that such reforms must include sweeteners to encourage more take-up.
The return on these funds is reflected in their investment policies. The funds are notoriously conservative and 70% of assets are invested in fixed income securities, with a paltry 12% invested in equities. There is also a lack of out-sourced management, despite the fact that a value of $172bn in 1998 makes it one of the larger markets in Europe. Less than a third of these assets is managed externally, although that is an improvement on the situation just a few years ago.
It is clear that serious reform of the system is being prevented by constant changes to the tax laws, few of which seem designed to improve the funding of pension promises. It is obvious that any such changes will have to fit into the current culture of retirement philosophy. In order to plug the gap which the social security system is creating, funding will have to provide not only pension income, but also disability and death cover.
Fortunately everyone concerned, from the politicians to tote trades unions to the employers’ federations, accepts that there must be reform sooner rather than later.
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