Germany
Compiled by Allianz Global Investors
Pension System Design
Germany’s pension system is based on a strong public pension pillar. In the past individuals relied predominantly on pension benefits provided by the statutory pension insurance. With the demographic challenges ahead this pattern is beginning to change and funded elements are gaining foothold.
Our projections indicate that the overall retirement market, which currently counts assets of EUR 1.07 trillion, will grow at a CAGR of 4.6% until 2020.
The “Riester Reform” in 2001 successfully started to revitalise occupational pension schemes and individual private pensions in Germany.
The milestones of the reform steps undertaken in the years since 2001 were the following:
- The 2001 Pension Reform introduced a tax-incentivised supplementary pension, the so-called “Riester” pension, to cushion the effects resulting from an adjustment of the state pension system and especially of the pension formula which will lead to a decrease in the replacement ratio for future pensioners. The “Riester” reform included several steps to promote occupational and private pension schemes.
- Retirement Income Act of 2004 completely changed the taxation system for statutory pension benefits and contributions. Over a transition period Germany switches to a deferred taxation system. Until 2025, contributions to the statutory pension system or to equivalent private products will become tax-free up to a limit of EUR 20,000 per annum. Simultaneously, pension benefits become fully taxable until 2040. In 2008 66% of combined employer and employee contributions to the statutory pension system are tax-deductible and 56% of pension benefits are taxed. What’s more, a sustainability factor linking the increase in state pensions to demographic and labour market participation development was introduced into the pension benefit formula on July 1, 2005.
Public Pensions
The German first pillar pension is a pay-as-you-go system financed by employees, employers and governmental subsidies. The contribution rate of currently 19.9% is equally shared between the employee and the employer with a contribution assessment limit of EUR 63,600 per annum (newly-formed German States: EUR 54,000 p.a.).
The legal retirement age is 65 for both men and women but is scheduled to rise to 67 years over a transition period from 2012 to 2029. An exemption will apply to insured persons with a contribution record of at least 45 years; they will be allowed to retire as hitherto with 65 years.
The pension entitlement is based on the number of contribution years, the average level of income and the retirement age. The average gross replacement ratio in 2007 was 51.7%, which is intended not to fall below 43% until 2030. Supplementary pensions should keep the replacement ratio on the current level. In general, the second pillar pension benefits will play an important role in maintaining the current standard of living during retirement.
Occupational Pensions
Occupational pensions are quite common among larger companies in West Germany, as well as in many of the medium and small-sized companies in some industries, such as manufacturing and banking. On average 46% of all employees have access to occupational pensions in Germany whereas only 41% of companies provide some kind of supplementary pension coverage for their employees. Pension coverage differs strongly by company size; 98% of companies with 500 and more employees offer a pension plan, but only 28% of the smallest companies.
Since 2002, employees have been legally entitled to tax-deferred compensation schemes, where the employee defers part of his salary today in exchange for pension benefits at a later date.
Contributions to direct insurances, “Pensionskassen” and pension funds are tax-free and exempt from contributions to social security up to 4% of the contribution assessment limit, which amounts to EUR 2,544 in 2008. This amount is stepped up by a fixed contribution limit of EUR 1,800, albeit subject to social security contributions.
Originally, the exemption from paying social security contributions on the tax-deferred amount to occupational pension plans was limited until the end of 2008. Broad resistance from major occupational pension representatives to this regulation prompted the government to extend the exemption irrespective of the huge losses for social security systems.
2nd pillar funding vehicles
In the German pension market, employers can choose between as many as five different funding vehicles. The five funding vehicles are:
1. Direct pension promise
2. Direct insurance
3. “Pensionskasse”
4. Pension fund
5. Support fund (“Unterstützungskasse)
Book-reserve accruals are still the most popular funding vehicle in Germany. In 2005, which are the latest figures available, still 58% of all pension liabilities were allocated to book-reserved plans. The share of book-reserved accruals is expected to decrease in the longer term, as the importance of external, asset-backed vehicles will increase.
With regard to the companies listed in the DAX, the German stock index, the funding level of pension liabilities increased significantly during the previous years. In 2007, 70% of the pension liabilities were funded through external funding vehicles. Rising corporate profits that allowed companies to transfer money to external funding vehicles, a slow increase of the overall interest rate level and a ongoing sound economic development contributed to a higher overall funding status.
Pension schemes funded via book-reserve accruals, support funds and pension funds are subject to the compulsory insolvency insurance provided by the Pension Insurance Association (PSV). All companies using these funding vehicles must pay an annual contribution to the PSV. If a company becomes insolvent, the PSV will take on the pension liabilities and thus ensure they are fulfilled.
1. Direct pension promise
Direct pension promises are usually funded via book-reserve accruals. The employer gives a promise to the employee to pay him a certain amount once he retires.
Tax treatment of contributions and benefits
The 4% tax-deductible contribution limit which applies to the external pension vehicles (“Pensionskasse”, pension fund, direct insurance) does not apply to book-reserve accruals. The employer can deduct the complete annual pension scheme contributions to book reserves from taxable income. The contributions are not considered taxable income to the employee.
Benefits are taxed as (deferred) salary when received.
Investment regulation
No investment regulations apply for book reserves. Tax regulation does not require book reserves to be backed through earmarked pension assets. In the past, pension liabilities were backed through the general assets of the company. However, due to changes in the international accounting principles and the regulatory framework, employers are increasingly “earmarking” specific assets for pension purposes and are investing them externally. By transferring the pension assets to a trustee via “Contractual Trust Arrangement” (CTA), companies segregate these funds completely from the general assets of the company. These assets are then regarded as “plan assets” and funded according to the international accounting standards, thereby removing the pension liabilities from the balance sheet.
Book-reserved pension liabilities can also be reinsured with a private insurer. In this case, the value of the policy is shown as a company asset in the balance sheet.
In recent years, some bigger German companies set up contractual trust agreements (CTAs) to fund their pension liabilities off the balance sheet. CTAs are legally separated from the sponsoring undertaking. They have been gaining popularity since they do not have restrictions regarding their asset allocation.
2. Direct insurance
Under a direct insurance scheme, the employer takes out a life insurance policy on behalf of the employee and pays contributions to the contract. The employee has a direct entitlement to the benefits accrued under the contract against the insurance company.
Tax treatment of contributions and benefits
Combined employer and employee contributions of up to 4% of the contribution assessment limit plus the fixed contribution limit of EUR 1,800 are tax-deductible. All benefits under new plans set up after 2005 are treated as fully taxable income. Contracts under the old law (taken out prior to 2005) are treated like new contracts if they qualify under the new rules. Otherwise they remain subject to flat-rate taxation during the contribution phase and provide tax-free lump-sum benefits or partly taxed annuity payments.
Investment regulation
Insurance companies are subject to supervision by the Federal Financial Supervisory Authority. Strict quantitative investment regulations apply to direct insurance, e.g. the share invested in equity may not account for more than 35%.
3. “Pensionskasse”
The “Pensionskasse” is the main pension vehicle for private employer-sponsored pension provision after the direct pension promise.
The “Pensionskassen” are special insurance companies that serve one or several employers. They have to comply with most of the regulations applicable to insurance companies. They can be set up as a mutual insurance association or as a joint-stock insurance company. There are single-employer or multi-employer “Pensionskassen” which are mostly founded by the financial service providers.
The “Pensionskasse” must be financed according to actuarial principles, ensuring that the necessary means to fulfil pension liabilities are available at any time. The guaranteed minimum interest rate for new contracts as of 2007 amounts to 2.25%.
Tax treatment of contributions and benefits
Combined employer and employee contributions of up to 4% of the contribution assessment limit plus the fixed contribution limit of EUR 1,800 are tax-deductible. All benefits are treated as fully taxable income.
Investment regulation
“Pensionskassen” are subject to supervision by the Federal Financial Supervisory Authority. Strict quantitative investment regulations apply, e.g. the share invested in equity may not account for more than 35%.
4. Pension fund
Pension funds are separate legal entities, which could be either formed as a joint-stock company or a mutual pension fund association. In the course of the Riester reform in 2001 pension funds were newly created. Insurance law regulates them. Pensions funds can be set up by a single company, a financial services provider or by an industry-wide pension scheme sponsored by the employers’ association and the unions.
According to new insurance regulation, as of May 2009 pension funds do not need to be 100% funded at all times. Pension funds will be allowed to have an under funding of up to 10%. In that case a recovery plan for a 10-year period is required.
Tax treatment of contributions and benefits
The same tax treatment applies as in the case of the “Pensionskasse”.
Investment regulation
The investment process follows the Prudent Person Principle. The freedom of investment is restricted by a capital maintenance guarantee that has to be given by the pension fund and ultimately by the employer.
5. Support fund (“Unterstützungskasse”)
Support funds are separate legal entities set up as an association, less frequently as a limited liability company, or as a foundation. The employee has no legal claim against the support fund but directly against the sponsoring employer. Support funds can either be sponsored by one single company or can be founded as a group support fund used by several companies.
Tax treatment of contributions and benefits
Contributions to support funds are tax-deductible without limit for both employer and employee contributions. Pension benefits are taxed as ordinary income.
Investment regulation
There are no restrictions regarding asset investments. The entire fund may even be lent back to the company at a market-related interest rate, which used to be common practice.
Outlook
The prolongation of the social security tax exemption for deferred compensation schemes, which was approved by the government in 2007, is the basis for a further positive development and build-up of supplementary pensions. Similar to most other European countries, retirement benefits from social security are expected to further decrease over the coming decades, which make additional pension savings essential to maintain a decent standard of living.
In 2008, governmental subsidies to promote supplementary pensions reached their maximum limit. Especially families with many children and high-income earners are those most benefiting from subsidies and additional tax-relief granted. The popularity for additional pension savings, both private and occupational, is expected to flourish.
Pension reform in Germany has aimed to encourage funded pensions to compensate for decreasing public pensions and to diversify retirement income. The stronger incentives for occupational and private pensions seem to be effective. Occupational pension coverage has increased. What is more, after a slow start, the third pillar Riester plans have gained wide acceptance and membership. Funding pension promises is an unbroken trend in the occupational market; the main question here is whether the Pensionsfonds will compete with CTAs or whether it will complement them. Another question is whether the Pensionsfonds can gain significant market share. In light of demographic projections for Germany, funded pensions will have to play a significant role in retirement income. This is a process that needs time, but is well underway.