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  • 2018/10/15
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Lessons from Germany’s pension reform

 

The national election cycle has ended in the major European countries; now, it’s on to pension reform. The debate in France is about systemic reform of the retirement system as part of the French President’s social agenda, which neighbouring Germany and Italy carried out in the 1990s, leading to a total change in the rules on pension rights accrual and pay-out. Those countries are now tackling additional modifications to their retirement systems.

The German case merits special attention, because to integrate the country’s economic competitiveness into the equation, the government decided to secure the system’s financing, while limiting the increase in the contribution rate.

Since 1992, the German system has relied on a point system with insured individuals accruing points throughout their career; the number of points accrued each year is based on a ratio of employee compensation to the average compensation of all insured persons. The number of points accrued is then converted into a pension using a coefficient at the time of pay-out at retirement. This coefficient drives the system (and makes it sustainable) by adjusting the pension level according to the life expectancy of each generation.

With the contribution rate set at 20% until 2020 and 22% until 2030, the choice was thus to reduce the retirement benefit and/or increase the retirement age. In 1992, the statutory age for pay-out was extended to 65. The 1992 reform was initially intended to stabilize the substitution rate*, but by 2001 the substitution rate could not be sustained, and individual, funded savings plans had to be created to maintain pensioners’ standard of living. The government consequently introduced a third pillar to the retirement system by subsidising complementary and voluntary individually funded pension insurance (“Riester pensions”), adding to the mandatory base system (1st pillar) and the occupational system (2nd pillar).

Meanwhile, wanting to ensure a certain visibility of the substitution rate over the medium term, lawmakers stipulated that new legislative measures would have to be implemented if it were deemed impossible to keep the contribution rate below 22% and the net substitution rate of the statutory pension above 67% through 2030. This is what justified the inclusion in the two new reforms in 2004 and 2007 of a sustainability factor in the coefficient for converting points and the increase in the full retirement age to 67 (by 2029). Sixty-seven was made the pivotal age: it was now possible to retire early with a 0.3% reduction in annual pensions or to delay retirement and benefit from a 0.5% increase.

In the German system, the priority is therefore on the financial balance of the basic system and no longer on maintaining the pensioner’s standard of living. With the last step in the reform of the statutory system, Germany entered into a defined contribution scheme, leaving no choice to future pensioners other than resorting to individual or collective private insurance or a longer working life to maintain their standard of living.

This priority has nevertheless resulted in the introduction of supplemental public contributions financed by tax revenues. This financial lever of funding through general taxation helps to understand the German obsession with budget surpluses.

When the new coalition announced that the substitution rate would be maintained at 48% and that the contribution rate would be capped at 20% between now and 2025, they were activating this very lever. The new coalition also agreed to increase pensions for women with more than three children, as well as for low wage earners who have contributed for at least 35 years. These financial commitments were made possible thanks to favourable economic conditions and accumulated budgetary surpluses over the past several years.

Does the federal government have the means to continue this generous policy, or are future retirement system reforms expected?

The reforms at the beginning of the 2000s only slowed the negative demographic impact on Germany’s public finances, while the ageing of the population will accelerate by 2030, significantly eroding the dependency ratio**.

The dependency ratio could increase from 34.8% in 2016 to 47% in 2030 and peak at 61.3% in 2070, according to a European Union annual report. Public expenditure related to retirement financing would increase in this case from 10.1% of GDP (in 2016) to 11.5% in 2030 and 12.5% in 2070, without changes to the current policy.

According to the estimates of the Munich Center for the Economics of Aging (MEA), the current substitution rate could be extended until 2023 without increasing the contribution rate and without allocation of a federal subsidy. Beyond this date, an additional €19 billion in financing would be needed to balance the system, and the gap could reach €22 billion in 2030 and up to €53 billion in 2040. Pension fund allocations, which now represent €93 billion per year out of a federal budget of €344 billion, would exceed 40% of the budget.

Possible alternatives

The most obvious is changing the equilibrium variables. Maintaining the substitution rate and the contribution rate without additional expenditure would lead to an increase in the starting retirement age to over 70 years by 2040. Maintaining the substitution rate solely by adjusting contributions would result in an increase in the contribution rate to more than 26% vs. 20% today. Given that the last increase in the starting retirement age is relatively recent, it is likely that the next government will prefer the option of decreasing the substitution rate, and possibly combining it with an increase in the contribution rate, to reduce the budgetary pressure of maintaining the system.

Immigration would increase the working population and slow the increase in the dependency ratio, and thus in public financing. But net immigration of more than one million persons per year would be needed in the 2020s to stabilise the dependency ratio. The arrival of a million immigrants in 2015 was regarded especially unfavourably by the population and precipitated the rise of the extreme right party (AfD), an experience that the next government will undoubtedly attempt to avoid. Another solution would be to increase the employment rate: maintaining the current parameters would be possible with the creation of 500,000 un-subsidized jobs per year. A significant pool is composed of mini- and midi-jobs, employment with reduced contributions that today account for 16% (7 million) of employees.

Another solution, albeit a short-term one, would be to finance the additional budgetary cost of pensions through an increase in taxes. The proposal by the German Social Democratic Party (SPD) to increase the top tax bracket from 42% to 45%, would yield only a small amount compared to the expected additional cost. Restoring a wealth tax could be more efficient but has already been rejected by the CDU/CSU. A tax on financial transactions could also be a viable solution, but would require an EU agreement that has been unsuccessful to date. An increase in VAT could also be proposed but would be generally unpopular because it has been broadly used in the past.

Lastly, new complementary funded retirement products are still being considered by the government commission that has been asked to prepare a road map for pension system sustainability and to propose a new form of intergenerational solidarity. The government is also attempting to strengthen the second pillar of the system, occupational insurance, that will allow companies to transform their defined benefit pension funds to a defined contribution system, thereby relieving them of their liability; this system is more easily achievable and favourable to SMEs.

* This is the percentage of the last revenue from working that a pensioner receives upon retirement

** This is the ratio of the over 65 population to the working population (15 to 64 years).

  

Paola Monperrus-Veroni et Philippe Vilas-Boas 

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