Complexity may hold back new plans' growth
The pension reform known as the ‘Riester package’ will be implemented with amendments to some 19 laws, and by introducing one new law for the certification of pension products for the third pillar. Most important is the introduction of a system of tax allowances and direct subsidies, which will be phased in over a six-year period commencing in 2002. Initially, contributions up to €525 will be tax deductible each year, and with increases every two years will reach €2,100 in 2008. Benefits arising from the scheme will be fully subject to tax.
Within occupational pensions, the reform gives employees a legal claim to defer pay up to 4% of the social security ceiling (€53,106 in 2001) to be contributed pre-tax, or alternatively, the employer can contribute the same amount. To this 4%, employees can add their third pillar allowances. As a result, tax-exempt contributions to occupational pension schemes in 2008 may add up to 8% of the social security ceiling as compared to approximately 4% in the third pillar.
In an effort to modernise occupational pensions, the government is introducing a fifth funding vehicle called ‘Pensionsfonds’ (Pension Fund). The above-mentioned tax allowances under the Riester package apply to contributions to a pension fund or to a Pensionskasse (and in the case of deferred compensation to direct insurance should neither of the former vehicles be available). Pension funds may choose to work on a defined contribution basis, but the defined contribution plan must guarantee the nominal value of contributions (net of risk benefit costs). This design was termed ‘defined contribution with minimum guarantee”, but we are tempted to have DCG stand for “defined contribution German style”. This German ‘Sonderweg’ of not allowing true defined contribution schemes is expected to restrict investment options and incur significant administration costs, and could therefore turn out to be one of the major pitfalls of the reform.
Pensionskassen will also be able to work on a DCG basis, which raises the question of what the real difference between a Pensionskasse and a Pension Fund will be. Like Pensionskassen, Pension Funds may be established in the form of a limited liability public company (AG) or a mutual insurance company, and in both cases will be subject to supervision by the Insurance Supervisory Board. Neither the solvency requirements nor the investment regulations for Pension Funds have yet been specified. Interestingly, the new German law refers to “imposing quantitative investment restrictions based on the EU Third Life Directive”. In this Directive, however, we could not identify any such restrictions except the rules established to provide sufficient diversification, which could also be acknowledged as general prudent man principles. Not more.
Social affairs minister Walter Riester has also introduced a whole catalogue of criteria which third pillar products must satisfy to qualify for approval. Amongst others, the provider must promise that at least the nominal value of paid contributions will be available at retirement. Furthermore, retirement benefits must be in the form of a life annuity or capital withdrawal plan which reverts to a life annuity at age 85 at the latest. Products can be insurance contracts, mutual funds or bank savings accounts. Investors are allowed to switch contracts and thereby product providers at the end of each quarter.
The difficulty for managers of third pillar funds thus lies in the requirement to issue a guarantee, while asset inflows and outflows will be hard to forecast for the individual product. To implement a hedging or portfolio insurance strategy, the fund manager must know the remaining maturity of the guarantees and the actual value of assets relative to the volume-weighted guarantee levels. If managers do not capture these data and if significant investor volatility and transaction costs are expected, they are left with the extreme strategy of investing contributions in fixed income and only the income generated in risky assets like equities. As the income only builds up over time, this strategy leads to the paradoxical result that young people would be initially invested in fixed income, only gaining equity exposure gradually and at a later stage.
Insurance companies are better placed to tackle this problem, as they can build up reserves and pool individual risks in order to smooth returns, whereas mutual funds must allocate investment gains (and losses) immediately. As a result insurers have been able to provide guarantees supported by asset allocation strategies alone without the need for specific hedging strategies.
The guarantee requirement combined with the potentially high mobility of investors thus imposes administrative burdens on third pillar products, which do not prevail to the same degree in the second pillar. Thus, given the different levels of tax allowances and different cost structures, we would assume that occupational pensions will see more inflows than third pillar products. At this stage, however, it is difficult to forecast which vehicle will pick up most contributions in the future, and to which extent ‘old’ vehicles will be transformed into ‘new’ vehicles. The lack of interest that industry has so far shown in the pension fund tends to indicate that ‘old’ vehicles are here to stay. The biggest drawback of the reform is clearly the high level of complexity, and we expect to see a transition period, hopefully also with amendments to the law after the next federal elections in 2002.
Nevertheless, given the Germans’ willingness to utilise tax savings of all forms, and given other factors like the unions’ eagerness to enter into negotiated agreements on pensions in the wake of the reform, we do expect potential inflows into the capital markets of from €33bn–53bn in 2002, growing to €75bn–110bn in 2008. This represents contributions based on the new system of tax relief for both personal and occupational pensions, with the assumption of a 40–60% utilisation rate of the maximum deductible contribution in each year. It must be assumed though, that a proportion of the contributions will not originate from reductions in consumption, but substitute capital investments that would have been made anyway, like employer contributions to ‘old’ pension vehicles, or life insurance savings. It will take at least another 12 months to be able to evaluate the net contributions as a result of Riester’s reform.
Gazing into the crystal ball, we expect the German pensions landscape in several years to look something like this:
q All employees within negotiated agreements will be covered by either a large corporate or an industry wide fund. The management of industry funds will be dominated by unions. Investment management will be largely outsourced to third party fund management companies.
q Insurance companies will offer standardised master products for small and medium sized companies that are not covered by negotiated agreements. Fund management companies will try to enter this market but will struggle with the provision of administration services. Only the larger players will operate profitably.
q Given the requirement of pension products to offer life annuities we expect to witness some degree of joint venture and M&A activity as funds management companies seek partnerships with insurers.
q Pension funds will offer their services also in the marketplace, ie, to other employees than those of the original parent company.
Given the significant inflows, and the potential of redistribution of assets already invested, many players will try to enter the market or defend their positions. Further harmonisation on the EU level will also allow for non-domestic competitors to gain their market share medium-term. At first sight, the law and the pension system give the impression of being created by typical German consensus politics, which would leave room for each segment and many products. At a second glance, however, we see the high complexity of products and vehicles. This will necessitate the creation of service and accounting systems and of advisory architectures. Investing in branding may become even more important also leading to higher costs. The next few years may therefore show who will be the fittest to survive in the German pensions business.
Peter Koenig and Sabine Mahnert are with the European pensions group of Morgan Stanley Dean Witter in Frankfurt