Luxembourg
compiled by Allianz Global Investors
Pension System Design
Although only a postage stamp-sized land with a population smaller than most cities, Lilliputian Luxembourg has become one of the most prosperous countries in the world. Known rather formally as the Grand Duchy of Luxembourg, the country and its 486,000 inhabitants consistently attain first place in European Union prosperity rankings, an achievement that is reflected in the generous nature of its pension system.
The Luxembourg system is designed with a public PAYG tier, as well as voluntary occupational and voluntary personal pension components. In addition to the PAYG element, the public pension is also partially funded by a reserve fund designed to cope with future demographic challenges.
The Luxembourg old-age dependency ratio is expected to increase from the current 8.5% to 31% by 2050. While this is significant, the rise is not as dramatic as that expected in other European countries. Indeed, the future dependency ratio of Luxembourg falls well below the European average, which is expected to reach 52% by 2050.
As a result, Luxembourg is one of the few countries not under acute demographic pressure to reform its pension system to ensure adequate retirement coverage for a dramatically growing cohort of elderly inhabitants. Instead, when reforms have been implemented in recent years they have actually featured generous first pillar benefit enhancements rather than reductions – a situation virtually unique.
Overall, the domestic pension market is considered small but Luxembourg has cleverly positioned itself to become a player in the growth of pan-European pensions. More than 155 banks, almost 60 life insurance companies and more than 2,500 investment funds are based in Luxembourg, making it the largest financial centre in the European Union for cross-border distribution of individual and collective savings and pension products.
Public Pensions
The Luxembourg social security system provides substantial retirement benefits based on two components: a flat-rate amount contingent on years of coverage and an earnings-related amount. Both components are financed through contributions shared equally between the employer, employee and state and amounting to 24% of wages.
The scheme covers all individuals economically active in the public and private sector. The self-employed are also embraced, although they pay 16% of net taxable income as opposed to the 8% contributed by insured employees. Minimum monthly earnings for contribution and benefit calculation purposes are EUR 1,503.24 (equal to the social minimum wage); the maximum earnings are set five times higher at EUR 7,517.12.
The normal retirement age is 65, provided at least ten years’ worth of contributions have been made. Every insured person with a contribution record of at least 20 years is entitled to public pension benefits. After 40 years of contributions (compulsory or voluntary), an individual can claim an early pension from age 57 onwards. The statutory retirement age is 65, but it is possible to continue to work and receive the pensions without suffering a reduction in benefits.
The 2002 pensions reforms increased the accrual rates for the earnings-related component, the flat-rate component and the minimum pension. Upon retirement, the recipient can expect a minimum monthly pension of EUR 1,353.29, as long as they have contributed for at least 40 years. The maximum monthly pension is capped at EUR 6,265.25. Benefits are indexed to changes in the cost of living and adjusted every two years in line with wages. In addition, a social assistance safety net is set at EUR 999 per month for a single person.
Of the monthly pension, the flat rate portion of the pension amounts to EUR 353.36 a month if the individual has contributed for at least 40 years (reduced pro rata for shorter contribution periods). An end-of-year allowance of EUR 50 per month boosts this, although the actual amount is also adjusted pro rata depending on the number of years of contribution. The earnings-related portion of the pension is based on adjusted lifetime earnings and accrues at a rate of 1.85% per year.
The accrual rate is higher for older workers and those who have contributed for longer periods. Each year of work after the age of 55 increases the accrual rate by 0.01 percentage points, as does each year of contribution above 38 years. The maximum accrual rate is 2.05%.
According to OECD data, the net replacement rate for mandatory pensions in Luxembourg is 96.2% (88.2% gross). In terms of public pension expenditure, outlay for pensions will rise from 10% in 2005 to 17.4% in 2005.
Occupational Pensions
In the past, companies have tended to address pension plans to higher-level employees, except for risk benefits that have been granted to all employees. Companies offering such a plan have three options as to the type of pension vehicle: pension funds, group insurance or book reserve schemes.
Traditionally, book reserve was the solution of choice as contributions to other funding vehicles represented taxable income to the employee. Reforms in 1999 eliminated the tax disparities between the different financing methods so the employer is no longer restrained in the choice of solution. In addition, the 1999 reforms introduced a broad framework regarding the protection of employee rights and company pension plans. These must be adhered to by all new and, after a stipulated transition period, existing plans.
In terms of pension scheme design, a defined contribution approach based on unit-link group insurance is becoming noticeably more prevalent. Under such a scheme, the employee can freely choose the investment allocation.
Pension funds
Pension funds are required to be independent legal entities holding pension assets separate from the sponsoring employer. The 1999 Pension Funds Law introduced two new types of fund vehicles: the Sociétes d’épargne-pension à capital variable (SEPCAVs) and the Associations d’épargne retraite (ASSEPs). The first of these is similar in structure to an investment trust, while the latter is a non-profit making association. In addition, a pension fund can also be created in the form of a non-profit organisation called ASBL.
1. SEPCAV
The SEPCAV (translated as Pensions Savings Company with Variable Capital) is a public limited company with a capital value equal to the net asset value. The members (future beneficiaries) are shareholders and own a set number of shares in the SEPCAV according to a net asset value per share, which is calculated on a regular basis.
The benefit is calculated as a product of the number of holding shares and the value of shares on the date of the payment. The whole benefit is paid out as a single lump sum. As a result, members benefit entirely from the investment income of the fund, but simultaneously bear the full investment risk. Because of this, SEPCAVs can only be offered as defined contribution schemes.
The minimum capital needed to establish a SEPCAV is EUR 1 million, a figure that has to be reached within two years of authorisation of the fund. A board of directors manages the company and can include a representative from the employer.
2. ASSEP
An ASSEP (Pension Savings Association) is not a company, but an association so members do not have direct ownership of assets. Instead, members are creditors and have a claim for payment of benefits against the ASSEP. Consequently, an ASSEP can be used for defined contribution, defined benefit or hybrid schemes. Depending on the scheme, benefits can be paid as either a lump sum or as an annuity. The minimum capital requirement is EUR 5 million.
Both SEPCAV and ASSEP vehicles can be set up as either single or multi-employer funds. They are supervised by CSSF (Commission de Surveillance du Secteur Financier), the Luxembourg banking and investment funds regulator. There are no restrictions regarding investment regulations on these vehicles. Both types of schemes are tax neutral in that taxation takes place at the investor level. This means that the rules pertaining to tax deductibility of contributions and of taxation on pension payments are those that apply in the country where the beneficiary is resident.
Asset management of the pension funds can be outsourced to authorised domestic or foreign asset managers.
3. ASBL
ASBLs (Association Sans But Lucrative) are intended for larger companies wishing to establish their own pension fund. The ASBL must be administered in Luxembourg and the sponsoring company is required to guarantee the solvability and liquidity of the pension fund at any given time. ASBLs are supervised by CAA (Commissariat aux Assurances), the Luxembourg insurance regulator, as this type of pension vehicle is created under the general provisions of the insurance law. Quantitative investment regulations apply to ASBLs. Rules applied to this legal form are simple and flexible and the pension fund could finance either DB or DC schemes. The pension fund can be “multi-employer” and administer several pension plans.
As the first pillar public provision is substantial, company benefit schemes have not been widespread. Those that did exist tended to focus on higher-paid employees in the financial sector and offered as part of an incentive package. In 2006 the coverage rate of occupational pension plans was 5.4% of the active population.
Changes within the tax system mean it is now more attractive for small and medium-sized businesses to offer direct insurance schemes to their employees or to link up with established SEPCAV and ASSEP structures to finance pension plans. Until now, tax disparities between the various vehicles meant that the overwhelming majority of pension plans have been funded via book reserves. Book reserve systems are non-contributory for employees, while employer contributions to any of the three types of pensions schemes cannot exceed 20% of salary.
Benefits paid out as a lump sum are tax-free. Any remaining annuity is taxable at a low rate.
Outlook
Much like in several other Western European countries, Luxembourg’s first pillar almost completely replaces wage income. For this reason, private and occupational pension provision lags behind most other European countries. The foundations for occupational pensions were first introduced in the late 1990s, and the coverage rate is very low. The extent to which this situation will change in the future depends on reforms to the public pillar.
Overall, Luxembourg is a small pension market, but the key objective of the 1999 legal framework was to create an environment more attractive to international pension funds. Luxembourg has long held the ambition of positioning itself as a centre for the management and administration of cross-border pension vehicles as it believes the future development of pan-European pension funds provide major advantages for multinational companies. These include enabling multinational companies to run different national pension schemes under one single “umbrella” pension fund to take advantage of economies of scale, simplified reporting from a single global custodian and administrator and greater consistency in quality of asset management and performance.
While true pan-European pension plans have not yet become a reality due to unresolved differences in tax, social and labour laws across Europe, Luxembourg is well positioned to take advantage of development cross-border pension markets when they do eventuate. The 1999 laws on international pension fund vehicles anticipated the 2003 European Directive on pension funds (known technically as “IORPs”), giving the country a lead on other EU countries.
With the set-up of the tax transparent FCP (Fonds Commun de Placement), Luxembourg aimed to develop itself as a centre for multinational pension pooling. In this way, multinationals can take advantage of economies of scale and the strength of the financial sector in Luxembourg. In the meantime, the pooling of pension assets to achieve investment management, administration and custody efficiencies provides a first practical step towards the creation of pan-European pensions and means Luxembourg is uniquely positioned to support international pension pooling vehicles.