The employee retirement benefit market in Germany continues to undergo drastic changes. Recent developments include new legislation in the taxation of retirement benefits, the movement of some companies to close their pension plans to new participants, the continuing trend toward the external financing of companies’ pension liabilities, and the centralisation of multinational firms’ pension management.
The Retirement Income Law (Alterseinkünftegesetz) was finally passed on 11 June 2004. This law becomes valid on 1 January 2005 and represents an extensive reform in the taxation of retirement income. This reform was necessary, as the Federal Constitutional Court (Bundesverfassunsgericht) decreed that the current provisions are incompatible with the German Constitution. The difference between the tax treatment of retirement benefits for civil servants and for all other employees was the trigger for the reform.
Furthermore, the Retirement Income Law brings essential changes in employee retirement benefits. For example, an employee who terminates service with one employer is entitled to have their vested pension rights transferred to their new employer (portability). A condition for such a transfer is that the pensions were funded by the former employer via direct insurance, via a Pensionskasse, or via a Pensionsfonds. The transfer right of the employee is limited to an amount up to the social security contribution ceiling (SSCC) which was €61,800 in 2004.
In practice, this means that the employee can only require a transfer up to this amount. The new employer is then obliged to provide a pension arrangement (equal in value to the transfer amount), using one of the above mentioned funding methods. With the transfer, the obligation of the previous employer is cancelled.
Should the pension entitlement exceed the maximum permissible transfer amount, the excess part of the entitlement has to be maintained by the previous employer. The employee must exercise their right to transfer the pension arrangement to the new employer within one year of the termination of the old employment contract. Otherwise, the transfer right is forfeited.
Additionally, the previously valid option to receive a lump sum severance payment from the previous employer instead of transferring future pension obligation to the new employer was discontinued. Low pensions (currently amounting to no more than €24.15 per month) represent the only exception here. Such pensions can be converted into lump sums without the employee’s consent, in a situation where the employee does not exercise their right to transfer the entitlement to the new employer.
Additionally, the level of tax-exemption for employee contributions (either to direct insurance, to a Pensionsfonds or to a Pensionskasse) which was 4% of the SSCC (€2,472 in 2004) has been raised by a flat amount of €1,800. This move has made the funding methods of direct insurance, a Pensions Fonds or a Pensionskasse more attractive. However, the absolute amount is still limited, especially considering the funding of pensions of senior management employees.
In summary, the new retirement income law is heading in the right direction, but there are still some areas which are still complicated or where one might expect modifications in the future, eg, the transition arrangement on deferred taxation and that the severance payment for new retirees is prohibited.
Reduction and withdrawal of pension arrangements
In January 2004 the subject of reducing employee retirement benefits in Germany hit the headlines. Triggered by the actions of a few major companies, the public began to question the acceptability of employers unilaterally cutting or reducing pension promises.
Since then public outrage has subsided, while companies maintained they were only redesigning or cutting benefits for future employees. In any event, unilaterally cancelling or a lowering the benefit level in a previously provided pension arrangement is, with few exceptions, not feasible in the German legal system. The Federal Labour Court (Bundesarbeitsgericht) compiled a detailed catalogue of how companies should deal with accrued employee entitlements.
Nevertheless, a large number of companies are thinking about ways of reducing their high pension burdens. Discussions here focus especially on the amendment of benefit plans for future new entrants, conversion of the benefit plans from defined benefit to defined contribution plans, and a stronger link with the employees’ own contributions.
Outsourcing of pension book reserves
In recent years, the outsourcing of pension liabilities has been a recurring discussion topic in the employer provided pension community in Germany. However, due to greater pressure from rating analysts, the capital markets and employees, its practical significance is now greater than at any time in the past.
The discussion focuses on an explicit funding of direct pension promises. In this arrangement, the funds for future fulfilment of the pension liabilities are not invested on the capital markets. Instead, pension book reserves are established as a liability on the company’s balance sheet. The advantage is a reduction in taxable profit and, in previous years, an inexpensive source of financing.
Later, since the benefits must be financed from ongoing cash flow, the company’s cash flow available for other purposes (capital expeditures, debt service) takes a drop. For this reason the credit ratings of several major German corporations were downgraded by the rating agencies. In the ensuing discussion it became clear that a standard assessment of the financial/economic impact of pension book reserves does not exist, either for rating agencies, or for experts in the field of employee retirement benefits.
Furthermore, the uncertainty of the situation was worsened by two factors increasing the burden on future cash flows for maturing companies: firstly, employee’s increased life expectancy, and secondly, a growing trend towards the use of early retirement schemes for company downsizing.
More and more companies are therefore accepting the notion that financing of company pensions through internally established book reserves is no longer feasible. Thus investments for pension financing must be externally funded, eg, in a Pensionsfonds, Pensionskasse or through an increasingly popular contractual trust arrangement (CTA). In such an arrangement, the pension book reserves that were established can be offset by dedicated assets within a CTA, according to international accounting principles (IAS, IFRS, UK-GAAP, US-GAAP). The result is an improvement in the company’s balance sheet ratios.
A number of DAX groups, including DaimlerChrysler, Deutsche Bank, Deutsche Telekom, e.on, HVB, Volkswagen, have externally financed some or all of their pension liabilities in recent years.
However, this subject is also relevant for small- and medium-sized companies. Since the introduction of the new equity capital regulations for bank loans (Basel II), banks will increasingly confront the Mittelstand companies about their pension costs as part of the credit evaluation process. Moreover, there is a real need for the outsourcing of pension liabilities in the context of the purchase or sale of companies divisions. Otherwise the winding-up of a company or part of a company could not be completed until after the death of the last pension recipient.
Since there are many ways to implement the outsourcing of pension liabilities, the legal framework in terms of both labour and tax must be taken into account. Unfortunately, an ideal solution does not exist. The decisions about the ‘if’ and ‘how’ of outsourcing must stem from a thorough analysis of the individual situation and needs of the company.
From observations of current market developments, it is anticipated that coming years will witness substantial capital transactions from companies to external providers.
Pension business appears on the radar screen of CFOs. The questions regarding pensions running through the minds of CFOs include the following:
q What impact could pension liabilities have on my credit rating and cost of capital?
q How will my EBIT/EBITDA be affected by pension cost volatility?
q How do I reduce overall pension costs? What is the minimum level of volatility I can take at the current cost level?
q How can I limit future cash contributions to my pension fund?
q Does my pension fund investment policy add value?
q Am I applying consistent risk control measures to my pension liabilities as I am elsewhere in my business?
Those considerations show that pensions aren’t viewed in isolation any more, but as a conjunction point of different parts of a company: the HR department ensures that plan designs are in line with corporate objectives. The accounting department has to reflect the pension costs in the company accounts. The finance department ensures the funding of the cash payments to the benefit plans, while the asset management department develops strategies for investing plan assets. Further on, the tax and legal departments are involved for tax and governance reasons.
What other challenges do we see in the market?
q Currently, there is an environment of increasingly transparent pension costs (eg, FRS 17, IAS 19), a volatile cost environment, a capital market situation with low bond and equity returns, a more complex benefit and regulatory environment and heightened analyst scrutiny (eg, rating agencies, equity analysts);
q There are a wide range of consequences for asset management. Because of the lower bond and equity returns and simultaneously rising risk sensitivity, institutional investors are seeking new ways to meet liabilities and reduce pension costs: Liability-matching strategies, liability driven asset allocation, search for uncorrelated alpha;
q The tendency of multinationals to centralise the coordination of retirement plans around the world is increasing. Financial management can help to develop a clear understanding of liabilities by country and business unit, to establish a quantitative measurement of underlying cost and risk levels, to implement a clearly defined process for measuring and monitoring these arrangements and to enhance overall investment returns;
q A ‘balance of power’ is developing between the needs of the corporate headquarters and the local plan fiduciaries. Tasks which are being centralised include investment and financing decisions, accountability and risk management. Tasks which are normally managed locally include HR policy issues and the selection of local advisors;
q Core/satellite investment strategies are being implemented to allow investors to generate higher returns without, for example, increasing the equity ratio. In a core-satellite-strategy the core-investment (eg, euro equity) is reduced in favour of more exotic satellite/classes (eg, emerging market equity). Satellite classes feature a lower correlation to traditional core asset classes and offer higher return with higher risk, but reduced portfolio volatility;
q Another way of achieving alpha is through the establishment of uncorrelated investments like a currency overlay, which separates the management of currency risk from the asset allocation and security selection decisions of the investor's asset managers.
The pension business in Germany continues to undergo dramatic changes these days. Companies are more closely monitoring the financial impact on the bottom line of any pension-related decision.
The ultimate goal is to control risk while maintaining to meet medium-term budgeted pension figures. To outperform their peers, companies must pursue their best risk-return trade-off and be willing to deviate from well-trodden investment paths of the past. Germany has the reputation of not being able to change quickly. In our view, the last two years have been a different story.
Herwig Kinzler is head of Mercer Investment Consulting. Torsten Schneider is a lawyer and senior consultant with Mercer Human Resource Consulting; both are based in Frankfurt