Too complicated for its own good
The German pension system is widely regarded as being one of Europe’s most complex. If that wasn’t bad enough, leading observers believe aspects of the reforms currently being discussed in Parliament simply don’t make sense.
“The devil is in the detail,” says Peter Scherkamp, managing director of German pension consultants Scherkamp and & Partner.
Far from encouraging the development of the corporate pension, which the legislators claimed was a key aim, the reforms appear to contain disincentives.
According to the current law which has been in force since the beginning of 2002, employees can make a contribution of up to 4% of the upper earnings limit for the statutory pension scheme into either of two of the three funding vehicles approved for the purposes of the Riester reform – Pensionskasse or a Pensionsfonds – which is tax-deductable. The interest accumulation on that amount is also tax-free but the benefit is fully taxable.
If an employee takes full advantage of the 4% allowance, he/ she or the employer on their behalf can additionally pay up to E1,752 into the third Riester-approved vehicle such as, direct insurance, or into a Pensionskasse. This is subject to flat rate of tax at 20% regardless of the marginal rate of tax. The advantage is that the interest gain on the net premium that lands in the contract is tax-free and the benefit at the end is also free of tax.
The reforms will abolish this flat rate for new contracts. “Contributions above 4% have no tax break at all—the marginal tax payer will be paying up to 50% tax on their contributions,” says Alf Ghodes, managing director of Buck Heissmann International Services.
The government has also put the three Riester vehicles on a level playing field. Currently, the flat rate does not apply to the Pensionsfonds, and the 4% tax-deductible contribution does not apply to the direct insurance scheme.
The German association of corporate pension schemes (ABA) approves of taxing pensions rather than contributions because, as general manager Klaus Stiefermann explains, “it increases the amount that is available to for investment purposes”.
“I welcome this unless pensioners have to pay the full rate of income tax on their pensions – which is what is being proposed,” says Ghodes. “But it’s no use having a tax break for the contribution if the benefit will be taxed.”
He adds: “The total tax break for contributions into these vehicles is being reduced. Now people are saying – very reasonably – that this is not conducive for the development of corporate pensions in Germany.” Stiefermann sees this reduction in the total as “critical”.
Stiefermann also believes that the consequence of the reforms will be that if the employee uses the full 4% to contribute to one of the three Riester-approved funding vehicles then none of these vehicles will be available for the employer to build an occupational pension. “What we do not need right now is legislation that damages occupational pensions,” he says.
The lack of separation of employer and employee tax breaks makes the whole system unworkable, as Scherkamp explains: “Whether the employee partly or fully uses this 4%, it will be administratively impossible for the employer to ascertain what each employee has done and therefore what, if anything, remains for the employer to invest. As a result, employer-financed contributions will only be possible through the internal book reserve.”
“In order to create a company pension scheme, companies need to be able to choose according to their business circumstances whether they remain with the internal book reserve or use one of the external vehicles,” stresses Stiefermann. “Small and medium-sized companies often choose an external form. Due to international accounting principles large companies often take this route as well.”
The Rürup Commission has asked for an extension of the tax-free allowance. “A doubling would help,” says Stiefermann. “This additional allowance should be used to stimulate the employer-financed occupational pension.” Buck Heissmann’s Ghodes is optimistic: “I believe that the Government will increase the tax ceiling from 4% to 6% or maybe to 8%.”
Scherkamp is clear about the need for a limit on employee contributions: “For the Riester schemes it is necessary to make a limit on employee contributions,” he says. “Otherwise the tax implications will be unpredictable.”
There is also an absolute limit of 4% on employer contributions into Pensionsfonds. Scherkamp is critical: “We don’t need a limit on employer contributions because they will not be additional – it’s just another way of funding pensions. A doubling of the allowance to 8% is an improvement, but 8% is just as arbitrary as 4%. There is no logic for any maximum. This cap must be abolished.”
He adds: “The internal book reserve is not capped and has not been abused, so why do we need a cap for external vehicles? If a company contributes more than 4% to its book reserve scheme, the cap will prevent them from transferring to an external vehicle because they will not be able to contribute as much. The result would be split-schemes. Companies must be allowed to make an appropriate contribution to their employees’ pensions, which for more senior employees will be more than 4%. If there is no change, companies will stay in the internal system and for accounting purposes make a contractual trust arrangement.”
The ministry’s main worry is that in the absence of a cap it will not be able to predict the level of financial risk. “But all of our demands are tax neutral,” says Scherkamp.
He adds: “the government may not understand – or is not really interested in the idea – that companies need to be able to transfer the book reserve to an external funding vehicle – without hindrance.”
This is what Scherkamp calls “the external twin”: everything that a company can do in respect of the internal pension scheme it should also be able to do with an external vehicle. “Companies would like to externalise their pension arrangements but it is extremely complicated,” says Scherkamp. “However, we only need four or five changes for the twin to function.”
There are two main obstacles to the transfer from an internal to an external pension arrangement. The first is that the amount that lands in the new vehicle needs to reflect the guaranteed rate of return of 2.75%. “This means that the liabilities and the means required for matched funding will explode,” says Scherkamp.
In the past, the book reserve was discounted at 6%, which compares to around 5.5% used in accordance with international accounting standards. “The guaranteed rate of 2.75% is prohibitively low,” says Scherkamp, “and there is no reason for it to be that low when the market rate is twice that level.” A rate of 2.75% means that in order to transfer a book reserve of 100, a company would need to pay around 130 into an external scheme. “So companies will find it very unattractive to externalise their pension arrangements at these funding levels – specifically, when looking at all the additional safety measures like solvency thresholds, employers liability and PensionsSicherungsVerein ,” he adds, referring to the pensions liabilities insurance fund.
“If no changes are made we will have a pension system that is incompatible with the rest of Europe. We need compatibility so that in the medium to long run we can also take in transfers from other European countries,” he says.
The second obstacle lies in the inclusion in the recent tax changes of a transitionary period so that the tax frameworks for each funding vehicle will be fully harmonised – by 2040. This means that until that time there will be differences in terms of the taxation levied on the benefits payable from each vehicle.
Therefore, if a company wants to change from one external form to another, or from an internal arrangement to an external one, it might put its employees at a disadvantage. Because of that it will have to ask its employees for permission to transfer. “The existence of discrepancies between the vehicles makes it cumbersome if not impossible for companies to opt for external pension vehicles,” says Scherkamp.
Ghodes has other worries: “the main concern is the significant administrative burden and compliance issues. I think the portability question should be addressed on a European level so that we can catch up with what is going on in UK and US.”
Portability also limits investment efficiency. Money may have to be transferred unexpectedly to another funding vehicle, so the individual schemes will need to maintain a certain degree of liquidity. This means that they can no longer invest money as efficiently as they could otherwise. Unfortunately this is an inevitable consequence of pension portability.
ABA’s Stieferman views the prospects for amendment to the proposed legislation with some optimism: “The legislators have now seen that if they do not take on board our recommendations the system of occupational pensions will be damaged. Nobody wants that and people are making great efforts to reach a reasonable solution.” He adds: “we expect that the problems will have been sorted out before the summer break.”
Ghodes shares the optimism: “We have a well-founded belief that the legislators will sort out these points—especially the tax situation.”
Scherkamp is more sceptical: “We are in discussion with the finance spokespeople from the different political parties as well as with the ministry but it is very hard work.”
Meanwhile at Commerzbank, the future of the company’s internal book reserve pension beyond the end of this year appears uncertain. “The internal scheme is guaranteed until the end of this year,” says a Commerzbank spokesperson. “The company’s pension arrangements are currently under review, and the meetings have been very constructive,” she adds.
“The politicians are gradually getting to grips with the subject of occupational pensions as they did in the past,” says Stiefermann. A damning indictment. Germany’s working population, already resigned to a less secure retirement, may be excused for regarding its legislators with some despair.