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Will Otto take on the pensions buck?

The German expression for the ‘man in the street’ is ‘Otto-Normalverbraucher’. Otto is the amorphous statistical average person, who according to the game plan of the current government is to be released from the warm embrace of the hitherto fairly comprehensive state pension system into the brave new world of personal freedom: the freedom of personal pensions. Company arrangements are to be excluded from the game.
As in some other industrialised countries, the writing on the wall has now not just been read by the current ruling coalition, but an actual game plan has been hammered out to do something about it. This, in itself, can only to be commended.
Ever since the end of the 1970s the German state pension system has undergone changes at regular intervals. Disguised as ‘reforms’ these amendments were mostly quick fixes rather than long-term solutions to the real issues. This is documented by the life cycles of only a handful of years on average. German reunification obviously also left its mark on the system, a development which was not foreseen in the long planning process culminating in the amendments that came into force in 1990. The amendments planned now will – if they are realised – really earn the label ‘reform’ because an element of voluntary pre-funding, if only modest, is being introduced. Also, companies are obliged to make appropriate vehicles available to absorb these additional voluntary contributions.
As in other industrialised countries, the underlying issue is essentially that of an ageing population causing an imbalance in the relationship between income and outgoings of a pay-as-you-go arrangement. The expected future increase in the development of the ratio of the working population to retirees intensified by a falling birth rate, longer education periods and early retirement, as well as rising life expectancy, lies at the heart of issue.
The projections performed for the government maintaining the current level of benefit provision, would result in social security contributions increasing from about 19% at present to well above 30% (shared equally between employer and employee). This already takes into consideration the fact that one quarter of the current DM400bn (e205bn) pension payments is financed not by contributions but by taxes (1% sales tax and a portion of the eco-tax). One solution discussed was to use the ‘hidden reserves’ in the employment market, such as by raising the average retirement age to, say, 68 or raising the ratio of female employment from 65% to, say, 80% or achieving an annual net immigration of workers of 800,000. However, with unemployment running at about 9% the ability of the German employment market to digest these hidden reserves is doubtful. Increasing the required government subsidies would effectively be a contribution increase coupled with a redistribution effect.
Needless to say, the game plan has changed significantly and rapidly in the past 12 months. What now remains is the following:
q Otto’s benefits, financed out of the present pay-as-you-go system, will be reduced from 70% of his final net salary to a still apparently generous level of 64%.
q The contribution rate to the state scheme will remain below 22% by 2030.
q The benefit shortfall can be filled by Otto himself by means of voluntary (third pillar) contributions to personal pension arrangement. Such contributions will be ‘encouraged’ by appropriate subsidisation.
If we have understood the game plan correctly, the net salary that determines the pension level at 70% is different to the net salary that determines the level at 64%. The reform proposes that beginning in 2002 a 1% increase every two years until 2008 will bring final contributions to 4% of gross salary (up to the contribution ceiling of currently about DM103,000 pa). These contributions can be applied as contributions towards personal arrangements and are subsidised by a tax free bonus payment by the state (DM300 for a single person, DM600 for a married couple and DM360 per child) or, alternatively, are deductible for personal income tax purposes. Now these contributions are taken into account when calculating the net salary. Consequently the level of Otto’s net pension will be at least 4 additional percentage points lower those calculated for him. Finally, the pension adjustment for pensions-in-payment are also in line with the newly defined net salary and will therefore also be lower.
The government states that, based on its calculations, it has solved the cost issue, at least until 2030. Looking at these calculations in more detail calls this conclusion into question, however. For a start, the economic assumptions used to achieve an equilibrium between expected pensions payments and future contributions are pretty optimistic. For example, it is assumed that for the years 2005 to 2030 average annual salary increases will amount to 3% in the old federal states to over 4% in the new ones. Unemployment levels, it is believed, can be reduced in this period from just under the present 4m to well under 1m. Apart from the economic uncertainty, there are a number of significant political uncertainties in the concept.
Politically, can the current generation of contributors be burdened with an additional 4 percentage point contribution that with contributions from 2008 of 10% from employers, 14% from employees (from 2020 the contributions are expected to increase to 11% and 15%, respectively)? Given that there is already a significant element of private savings a substitution effect will certainly take place. With or without a subsidy, the present generation of contributors will in future have to foot the bill of underfunded pensions of the previous generation. These, the present and soon-to-be-pensioners will only have to bear marginal losses through lower pension adjustments.
In summary, the buck has been passed to Otto but will he realise this today? Will the consequences be explained to him clearly? We guess that this will be a tall order indeed.
The current game plan for the second pillar is, in short, that there isn’t one – at least not with a new one. The maximum vesting period is to be reduced for employer-financed arrangements from 10 to five years and the minimum age from 35 to 30, with voluntary employee contributions vesting immediately. To partially compensate for the reduction in the general vesting period, book reserve accruals and contributions can now commence at age 28 instead of 30. Other than that, the current legal framework for company pensions has remained largely unchanged.
Against a background of European efforts to bolster pan-European company pension funds and the harmonisation of the relevant legal framework, the German concept appears somewhat surprising since it targets private pensions alone.
Instead of encouraging the harmonisation of the various current vehicles for occupational pension provision in a European context, for example, by improving the tax deductions for contributions to support funds, the draft legislation just tweaks at these. This is not going to stimulate occupational pension arrangements in Germany. Despite the European-wide discussions on a location for pan-European pension funds, it appears that the government has not understood, that with their reform they worsen Germany’s chances of being a major player in the global financial market. If the draft goes through as planned, German companies will be tempted into investing in pension funds in those foreign jurisdictions to circumvent local investment constraints and restrictions on maintaining soundly funded arrangements. Only by setting up complicated entities so that they can also enjoy almost equal treatment of their pension liabilities as their foreign competitors.
Norbert Roessler and Alf Gohdes are with Buck Heissmann in Wiesbaden

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