The current reform of Germany’s pension system has signalled a change in attitude to liabilities. The belief that assets can always match liabilities was summed up in the complacent government catchphrase “your pension is safe”. This certainty has been replaced by a growing sense that liabilities have grown too large and that something must be done to build up reserves to fund them.
Nowhere is this more evident than in civil servants’ pensions. German public service pension schemes, which cover civil servants and public sector employees, have been forced to confront the problem of funding over the past year.
The scale of the problem is immense. Civil servants working for the federal government, the Länder and the municipalities together account for 1.5m active members and 740,000 pensioners, to whom e18.4bn is paid in pensions. However, little or nothing has been put aside to fund this.
The size of the liabilities overhang is difficult to gauge. Public authorities do not publish details of their pension liabilities. Dirk Popielas, executive director of the pension services group at Goldman Sachs in Frankfurt, says he believes the authorities are seriously understating their total liabilities. State and Länder liabilities are typically within the range of 50–60% of assets. However, Popielas says this figure does not include pension liabilities. Once these are included, total liabilities rise to 120–130% of assets in some cases. “That’s too much debt,” he says, “The amounts are huge. There is no precedent in the history of financial accounting for anything on this scale.”
Popielas blames the Ponzi-style pay-as-you-go (PAYG) pension system of civil servants for the shortfall. “The problem is there are no book reserves, no funding. It’s really a pure PAYG system. At the moment there is not a single Deutschmark received from today’s active civil servants which is spent on pensioners.”
However, pressure to introduce some form of funding is increasing, as the number of active members of pension schemes decreases and the number of pensioners swells. Introducing an element of funding will be an immense task, Popielas says. “They have to move from zero to 10%. That’s a hell of an increase.”
The problem of liabilities is complex. Civil servants’ pensions are made up of two components – the basic pension, a pure PAYG system, and the supplementary pension, which is a part-PAYG, part-reserve system. The VBL, the pension institution for the state and the Länder, and the AKA, the association of 22 municipal pension institutions plus five institutions for churches, pay the supplementary pensions.
The basic civil service pensions of the federal government and the Länder are PAYG systems, financed by the budget with no provision made for the future. Civil service pension systems at the municipality level are slightly different, since here a limited amount of capital has been accumulated.
The civil service supplementary pension is financed by employers and acts as a top up scheme. Added to the basic pension, it provides benefits that can be as high as 91.75% of a civil servant’s final net salary.
However, coverage – the ratio of capital to the annual amount of benefits – has been declining steadily in recent years in most of the supplementary pension systems. The coverage ratio within the supplementary system of the federal government and the Länder declined from eight in 1980 to about 2.5 by 1997. Supplementary pensions in the municipalities have a coverage ratio of between 10 and three.
The supplementary pensions for church staff, however, are well covered. This is chiefly because, in the past, they required a much higher contribution rate from their member employers than did the government supplementary pensions. Some of these schemes have a coverage ratio of more than 20.
Government institutions at federal, state and local level are realising that they need to build up some capital to provide for an adequate coverage ratio. In 1998, the contribution rate of federal government and the Länder pension funds was raised by 0.4% to 5.2%.
The federal government has also realised that the lack of capital will cause substantial problems for the financing of pensions from 2008 onwards with the expected sharp increase in the number of pensioners up to 2025.
It has therefore introduced a plan in 1998 to build up pension reserves by restricting the annual increase in income (a scheme known as income renunciation) of active civil servants and pensioners. Under the plan, the annual adjustment for civil servants and pensioners would be 0.2% less than the adjustment for public sector employees and workers.

This represents a 3% decrease in salaries and pensions until 2014. The money saved will be used to finance a pension reserve, which would take the pressure off budgets during the critical period between 2008 and 2015. Both active civil servants and pensioners will contribute to the building of this reserve. The pension reserve will only become available for the payment of pensions in 2014.
However, the government put this plan on hold in June, when it introduced legislation to cut civil service pensions. Under the government’s bill, from the beginning of 2003 civil service pensions will be reduced in eight stages to produce a total decrease in payments of 5%,
To compensate for this, the government proposes to suspend the current levy of 0.2% on each salary increase between 2003 and 2010. In addition, members will be given the opportunity to build up a money purchase pension under the new pension reform law. In other words, they will be able to offset the reduction of their future pension by building up savings with tax incentives.
Savings from these measures could total e60.59bn by 2020. The federal state’s share would amount to e8.44bn and the municipalities’ e6.24 bn. However, the biggest savings would be made by the Länder, since they employ the largest number of civil servants. Their savings have been put at e46.91bn.
The bill was before the Bundesrat, the chamber that represents the Länder, as we went to press. However, the government expects to get strong support for the legislation.
The corporate sector does not face funding problems on the scale of the public sector. Popielas points out that companies have a number of options. “All companies find some way to pre-fund,” he says. “There are always some assets and the balance sheet is always balanced. For companies the decision is only whether this financing is done in-house or externally.”
However, the adoption of international accounting standards by leading German companies has highlighted the problem of liabilities and underfunding, according to Gordon Clark of the school of geography and environment, Said Business School in Oxford and his colleagues Daniel Mansfield and Adam Tickell.
Clark and his team say that that one effect of German companies conforming to international accounting standards (IAS) could be to accelerate the progressive shift from unfunded to partly or wholly funded pension vehicles. They point out that there has been a significant shift over the past 10 years by large German companies away from Direktzusagen (unfunded corporate schemes) towards the Pensionkasse (underfunded schemes). There has also been a move to increase the funding of Pensionskassen, which has the effect of reducing the overall reported corporate pension liability
They conclude that the new accounting requirements will significantly affect the treatment of liabilities. “International accounting standards will re-write long-term pension liabilities, not counted against current income in German accounting practices as short-term liabilities. Thus the underfunding of long-term pension obligations characteristic of Ditrektzusagen and common to corporate Pensionskassen funds will be charged against the current value of the firm - translating to lower market prices.”
The knock-on effect could be serious for these companies, they conclude, since lower market prices could make them vulnerable to hostile takeovers by competitors.
One way of avoiding this problem posed by international accounting standards is to create a vehicle that is both within and outside them – the pension trust. This is a US-style, fund-based supplementary pension system. Peter Koenig, executive director at Morgan Stanley Dean Witter in Frankfurt, says that the development of the pension trust was an ingenious German solution to a German problem: “It means that you can be on-balance-sheet in Germany but off-balance-sheet in IAS.”
Currently 10 pension trusts are licensed in Germany. By far the largest is the Siemens pension trust with fixed assets of some DM 20bn (e10.2bn). It was developed in 1999 when Siemens prepared to list on the New York Stock Exchange. One of the conditions of listing was that it should conform to GAAP accounting standards.
Volkswagen has also switched from a PAYG company scheme that cost DM 1.5bn–2bn a year to a pension trust. Volkswagen says the new vehicle will invest its funds freely in the markets and enable the company to increase payments to its retirees. It estimates that if the market value of investments increases at an annual rate of 10%, the company can guarantee workers a 3% annual pension increase.
Pension trusts may have squared the circle in Germany by controlling liabilities and ensuring that pensioners’ expectations do not exceed a company’s ability to pay.

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