On 11 May 2001, the pension reform bill passed the Bundesrat. The pension reform being effective as of 1 January 2002 provides tax incentives and tax allowances to enable the workforce to build-up an individual asset funded pension benefit on a voluntary basis. The introduction of the supplementary private pension is to make up for the reduction of the pay replacement ratio in state pension system which is supposed to decrease from 70 % to 67% of the last net income. However, one has to keep in mind, that this benefit level requires 45 years of paying contributions to the mandatory state pension system and an average income for the whole period being covered by social security. For this reason the average individual net pension will be in fact lower. It can be expected that the state pension in the future will not be sufficient to provide for a standard of living when people become retired. Especially the younger employees have to recognise that it will become more and more their own responsibility to secure their retirement income. Most of the developed countries in the world are struggling with the same problems in financing first pillar systems facing lower birth rates, a steady increasing life expectancy and rising unemployment-ratios.
Nowadays in Germany three employees have to finance the pension of one pensioner. Until 2050 at the latest it will be only two employees financing one pensioner.
The most important goal of the reform is to stabilise the employer/ employee contributions to the state pension system by not more than 22% until 2020 and under 23% until 2030 (currently 19.1%) by introducing an additional private and asset funded pension system. The increase of 0.1 percentage-point would equal to an additional expense of about E1bn.
One measure to achieve this goal is to reduce the level of benefits provided through the state pension system. Experts say the reduction won’t be enough. The future will show if further corrections will be necessary. To substitute the decreasing level in the state pension system every eligible employee is called upon on a voluntary basis to secure his standard of living after retirement on his own through building up an asset funded private or occupational pension benefit. The employees therefore have the alternative between company pension schemes (second pillar schemes) and individual private contracts (third pillar schemes).
If the employee chooses to build up a pension benefit within the third pillar he has to sign an so called ‘Altersvorsorgevertrag’ (personal old age contract) which has to satisfy a set of detailed criteria to qualify for tax reliefs on the contributions being paid.
Every entitled employee (those mandatorialy covered by the state pension scheme) who joins the new system will get an extra tax allowance. To qualify for the extra tax allowances, the employee will have to allocate a fixed amount of his yearly gross income up to the contribution ceiling to social security to fund the additional pension benefit. Starting in 2002, the employees have to allocate 1% rising in steps to 4% in the year 2008. The extra allowance amounts to E38 per year for the employee himself and E46 per year for every child not over age 18 or age 27 if completing a traineeship or a study for example. These amounts also will be increased in steps to E154 per year respectivly E185 per year.
Because of the effectiveness of the second pillar schemes the pension reform also contains some major amendments on occupational pension schemes. They are aimed to strenghten especially the collective organised company benefit schemes as they secure high efficiency comparing to private inividual pension contracts.
In Germany, until 2001, there were traditionally four funding vehicles for occupational, (see chart). Within the pension reform a fifth funding vehicle, the Pensionsfonds, is being implemented. But that doesn’t mean in Germany the pre-conditions have already been set up for true defined contribution ‘plans’. To understand why this didn’t take place one has to see the reform within the social and political context. As the pension benefits arising out of the newly introduced private asset funded systems will have to substitute in part the state pension the legislator decided to set the framework for a maximum of security and stability of benefit levels.
To secure that any employee will have access to build up an asset-funded pension the reform also sets an important change in the world of occupational pension schemes. Until last year every employer was free to decide whether or not he would offer a company pension scheme. From January 2002 onwards every employer with employees covered by the state pension scheme, has to provide a company pension scheme open to salary conversion. Any eligible employee is now entitled to ask his employer to use up to 4% of his wage covered by the contribution ceiling to social security for a company pension benefit. If an employer has already a company pension benefit scheme funded through salary conversion in place, the employee is barred from claiming such a right in the respective amount.
The employee is further entitled to ask his employer to make sure that his pension benefit scheme is encouraged for the extra allowance (the so called ‘Riester-Zulage named after the Minister for labour and social of Germany, Walter Riester) and the tax reliefs.
Not every occupational pension plan or funding vehicle is qualified for tax reliefs. Encouraged funding vehicles are the pensionskasse, the direct insurance and the new pensionsfonds. Non-encouraged funding vehicles are the support fund and the direct pension pledge, which are regulary financed internally via book reserves.
If the employer is willing to deliver the benefit via a Pensionskasse or Pensionsfonds, this funding vehicle has to be used by the employee. The employee therefore is not entitled to ask for another funding vehicle. In absence of such an offer the employee is entitled to ask for the execution of a direct insurance contract. Pensionskassen and Pensionsfonds therefore can be offered as a mandatory financing vehicle. The alternative for the employee is to choose a individual pension contract within the third pillar.
Regarding to the salary conversion the pension reform contains one very important detail. As far as compensation entitlements are based on a pay tariff agreement, they can only be subject to a salary conversion, if there exists an corresponding opening clause within an tariff agreement or an special tariff agreement for salary conversion. In the absence of such an opening clause only those parts of the compensation which are above the pay tariff agreed wages can be used for salary conversion. That shows the rising impact of tariff politics. A number of special tariff agreements have already been negotiated and also funding vehicles for tariff pension vehicles will be or have been installed in several branches.
Especially insurance companies will set up Pensionskassen and Pensionsfonds to be able to compete effectively through a variety of vehicles for company pension schemes, as the second pillar is considered as a booming market.
As a result of the reform the pension market in Germany will undergo major changes. It will be interesting to see the outcome on the development of the different funding vehicles. But one is for certain. There will be more competition, more transparancy to products and expenses and also to the investment returns.
Another issue are the specific investment and capital risks according to the pension plan and the offered funding vehicles. The employer has to decide what amount of risk he is willing to take, because the employer will be liable for all the benefits provided through the funding vehicles, irrespective of the type of funding vehicle.
As a sum up the pension reform is a big step into the right direction while concentrating and encouraging external asset funded schemes. However, the complexity will increase.
Joachim Schwind is chairman of the board of Pensionskasse der Mitarbeiter der Hoechst-Gruppe in, Frankfurt /Main and deputy chairman of the board of aba, in Heidelberg. He is also head of the Mutual Insurance Association (Pensionskassen) of aba.
Ralf Klein is co-head of insurance business department of Pensionskasse der Mitarbeiter der Hoechst-Gruppe