The pension reform enacted on 11 May last year was described by labour minister Walter Riester as the biggest reform since the war. Whether this is true or not, it does not mean that there will be nothing left to do in the next decades.
A basic fact in politics is that the period after one reform is the period before the next reform. And the German pension reform is no exception. Nevertheless, it may be expected, independently of the results of the general elections in September, that no major pension reform will be necessary in the years ahead – emphasising the word ‘major’. In this respect the reform deserves the description ‘sustainable’. On the other hand, during the reform process calculations were made for the period up to 2030. And I am convinced that further major reforms will have to be undertaken in the meantime. What options do we have in this respect? Paragraph 154 of the German Social Code VI gives a number of options and limitations. This paragraph itself is of course not holy writ – it may also be subject to changes in the future.
It lays down that the contribution rate must not exceed 20% up to 2020 and 22% up to 2030. The last long-term calculations for the period to 2030 were made in May 2001on the basis of the whole reform package. They show that these targets may be met. But this is of course influenced to a high degree by the underlying assumptions concerning employment, wage development and immigration – to name only the most important.
Another target laid down in paragraph 154 is that if the so-called standard income replacement ratio falls below 67% in the 15-year long-term calculations, the federal government is obliged to propose legislative action. The standard income replacement ratio is defined as the ratio between a standard pension (that of someone who has paid insurance contributions for 45 years while having received an average income) and the current average net wage. Combining this provision with the target for the maximum amount of the contribution rate, only a small path remains for government intervention into the system.
Subsidies from the federal budget account for about one third of the revenues of the statutory pension insurance, about e65 billion annually, which is almost 25% of the federal budget. This also means that there is little or no room – at least in real terms – for a further expansion of this kind of subsidies to the statutory pension insurance.
What other options are there to keep the system sustainable, and at the same time ensure that the people trust in its reliability, if there is only limited room of manoeuvre on the revenue side? There are several options.
The first and logical option is to alter the pension age – both the statutory as well as the average pension age. These two are not identical. Rising life expectancy inevitably leads to longer average periods of pension receipt. The adequate instrument to limit this process would be to extend the employment period by raising the pension age step by step – for example, from the current age of 65 to 67. The US example proves that this is possible.
This does not necessarily mean that the effective pension age will also be 67. People may retire earlier – for example, because they receive disability pensions or simply because they use other legal age limits that will continue to exist. But we will gradually introduce a system in which those applying for early retirement pensions have to pay a price for it in the form of pension deductions. In general, 0.3% of pension benefits is deducted for every month people retire earlier than the age of 65. So, if somebody retires at 60, this amounts to a deduction of 18%. That hurts, and should constitute a considerable disincentive to early retirement. But we still have too little experience with these new rules to be able to report on their effectiveness.
Raising the statutory retirement age to 67, for example, would mean first that this deduction has to be increased. It would also mean that the flow of contributions to pension insurance will continue if the person decides to remain in the labour market. On the other hand – and this must not be forgotten – it also means that the eventual pension will increase, as the insurance period will be extended and deductions will be avoided.
The 2001 pension reform introduced a new instrument for old age security: capital-funded private old age security promoted by the government. This system started in 2002 with a minimum saving of 1% of gross income earned to get the maximum subsidy. This minimum saving amount will reach 4% of gross income in 2008. The maximum subsidy will then be e154 annually for an individual plus e185 per child.
This mechanism is also part of the new pension adjustment formula. The basis for the annual wage-related pension adjustment in the year n is the development of gross wages in the economy in the year n–1 versus the year n–2. Then changes of the pension insurance contribution rate and the percentage of promoted private saving (in steps of 0.5% annually, which diminishes the adjustment rate) are considered. Together, this constitutes the annual adjustment rate for pensions. So, the final stage of this mechanism will be reached in 2010, when a then constant 4% will be considered. Thus, the adjustment formula is based on the implicit assumption that all those who have an entitlement to the subsidy actually participate in the scheme.
Changing the rate from 4% to 5%, for example, would mean a reduction of the annual pension adjustment and have a financial impact that would prevail in future. To give an example of the dimensions at stake: 1% of pension adjustment means an annual spending increase or decrease of e2bn.
Another potential for saving on the spending side of statutory pension insurance is in survivors‘ pensions. This potential was hardly used in the pension reform, despite the fact that, in the early reform plans, the government had intended to freeze the amount of earnings offset for the entitlement to a survivor’s pension. This was given up after long discussions with the opposition parties. What remained a part of the reform is a reduction of the entitlement from 60% to 55% of the pension of the deceased spouse. This applies only if the couple did not have children and if both spouses are younger than 40 years (all marriages concluded after 2001). In all other cases, the old legislation applies. If the couple did raise children, there is a compensation for the reduction that in most cases will lead to a higher survivor’s pension than according to the old legislation. As a result, if the new rules have any financial impact at all, it will be in the very long run.
No doubt there is still a justification for survivors‘ pensions but this justification is diminishing from year to year, also due to a necessarily rising labour market participation of women against the background of the foreseeable demographic development. At the same time, for every child born after 1991, three child-raising years are credited (for children born before 1991 it is one year). These provisions also add to the new rules introduced as part of the 2001 reform designed to encourage especially women to re-enter the labour market – for example, by way of part time employment after a child-raising period. As a result, the amount of about e30bn now paid in survivors‘ pensions will potentially contain pension insurance expenditure in the future. The idea of freezing the amount of earnings offset to gradually depreciate the resulting survivor’s pensions remains a key to open up new opportunities for saving here.
The reform was not limited to the statutory pension insurance alone. One of the major targets was strengthening the second and third pillars of the old age security system. So far, 160 collective agreements have been concluded which offer opportunities for additional pensions within the framework of occupational pension schemes. Most of the arrangements under what is in a somewhat simplified way called the ‘Riester pension’ will be made with such schemes.
The ministry of labour and social affairs estimates that in the future about two thirds or three quarters of the 30m people who are entitled to the government-promoted pension plans will use the new opportunities in conjunction with occupational pensions. The rest are expected to make use of other private arrangements with banks, insurance companies and other enterprises offering financial services.
In fact, the real core of the reform is creating these new opportunities. By 2008, the ministry of finance expects e12.7 billion to be spent on subsidies/tax relief in connection with strengthening the second and third pillar of old age security. The use of these newly created instruments will more than compensate for relative losses in the statutory pension insurance.
Bert Rürup is professor, Department of Economics and Public Finance, Darmstadt University of Technology