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Another pension reform in Germany
In September 2000, The Multinational focused on the problems that
global ageing is posing governments as they seek to secure the
retirement income needs of their citizens. Potentially, Germany is
among the worst placed countries to confront the challenges of
ageing. It suffers from the conflicting pressures of generous retirement
provision from its current unfunded social security system and a
population profile where - according to recent estimates by the US
Bureau of Census - by 2050 the over eighties will be greater in
number than the under twenties and whose working-age population is
projected to fall by 43% by 2050.
In August 2000, the Labour Minister
announced the Government's intention to
present a bill to substantially reform (and cut)
state pension provision. Not surprisingly, the
proposal met with strong opposition from
labour organisations. However, after a long
and controversial debate, the German lower
house approved the proposals in January. Most
sections require the approval of the Bundesrat,
the upper house, where the Government does
not have a majority. The Bundesrat rejected
some details of the Reform and referred it to
the Intermediate Committee for further
consideration. Although a decision is
scheduled for the end of March, at the time of
writing it is not clear whether this timetable
will be met. What is clear, however, is that
even if some details of the reform change, its
overall structure should remain untouched.
The aims of reform
Given the current financial difficulties of the
social security system, the proposed reforms
are intended to be sufficiently comprehensive
to secure the financial stability of the system
in the long term. It therefore affects
occupational pensions and private savings,
not social security in isolation. It also seeks to
broaden private savings for retirement, and so
is strengthening the funded portion of
retirement provision. To achieve this, private
savings up to 4% of income (with an upper
limit of 4% of the social security ceiling) are
to be tax favoured or alternatively supported
by state subsidies. This is to
be phased in gradually until
2008. As a counterbalance,
social security pensions are
to be reduced.
To benefit from tax
favoured status, savings
vehicles have to meet certain
requirements regarding risk and administration cost: certain limits
may not be exceeded and there are
restrictions on the timing and nature of
benefit payments - essentially, lump
sum payments and settlements are not
allowed. In addition, a full refund of
the savings portion of the contributions
has to be guaranteed.
How will the reform
impact occupational
pensions?
As it is the intention to relieve the
pressure on the state system,
occupational pension schemes will be
strengthened in addition to private
savings, and a number of changes are
being introduced to achieve this,
principal among these being:
New definition of
disability
Although passed at the end of last year,
this amendment of social security rules
is often seen as part of the overall
reform. The definition of disability is
now based on the number of hours an
employee is able to work. This figure,
in conjunction with the availability of
appropriate part-time employment,
dictates whether a full or
50% pension is paid (the
latter assuming that the
employee continues to work
on a part-time basis). In
addition, disability pensions
will only be provided as
temporary benefits (usually
for a three-year period).
What does this mean for employers?
As most occupational pension plans
link the conditions under which a
disability benefit is granted to the
requirements of social security benefits,
these plan rules will have to be
re-defined. In addition, most pension
plans only pay disability pensions after
the employment relationship has been
terminated. Therefore, employers have
to decide on the following:
- Will a disability benefit become
payable also in case of a dormant
employment contract?
- When a partial social security benefit
is paid, will the company grant a 50%
disability pension in addition to the
social security benefit?
Reduction in legal
vesting requirements
Viewed internationally, German plans
currently have a long vesting period:
10-year plan membership with a
minimum age of 35. These
requirements will reduce to 5 years and
age 30 and will apply to all promises
given as of 1 January 2001. For
employees already in a pension plan at
that date, transitional arrangements will
apply. To provide a certain amount of
tax relief for these more generous
vesting conditions, tax-deductible book
reserves and contributions to support
funds will be increased by reducing the
minimum financing or funding age
(i.e. the minimum age at which book
reserves may be accrued or
contributions may be paid) from 30 to
28 years.
What does this mean for employers?
For employers, whose plans adhere to
the strict legal requirements, this
implies an increasing liability – very
roughly, the additional gross cost is
estimated to be between 3% and 8%,
depending on the average turnover.
This charge, however, can be
compensated at least in part by a higher
tax deferral depending on the profile of
the workforce. If shorter vesting periods
have already been promised in order to
make the plan more attractive, then
with the introduction of this law this
competitive advantage is reduced or
even disappears.
Introduction of DC
plans
For the first time, the Occupational
Pensions Act contains a full definition
of a defined contribution (DC) plan, to
be implemented through the newly
introduced pension fund (see page 3), a
Pensionskasse or a direct insurance. The
accumulated contributions, after
deducting any allowance for risk
coverage, have to be guaranteed as a
minimum benefit.
What does this mean for employers?
DC schemes financed via direct
insurances or Pensionskassen already
exist. As these vehicles generally
guarantee a positive interest return on
the savings part of the contributions,
the main impact of the new regulation
relates to the new pension fund.
Strengthening mirror
DC programs
Mirror DC plans, financed by the
employer or via salary deferral, have
become quite popular in Germany.
These are book-reserved arrangements,
with or without external asset backing,
where the pension results from annual
(notional) contributions plus interest
(either based on a fixed, guaranteed
interest rate or on the return achieved
on the external assets). Such plans can
quite closely resemble a DC plan, but
without funding or investment
restrictions. Until now, one of their
main problems has been the fact that
the legally vested entitlement can
exceed the accrued contributions plus
interest by some way, especially if an
employee has been in service for a
lengthy period prior to the plan's
introduction. This is particularly the
case with deferred compensation
arrangements. In future, the legally
vested entitlement will be equal to the
accrued contributions plus interest.
What does this mean for employers?
In future, it will be possible to have a
mirror DC plan without the hitherto
complicated vesting regulations. This is
particularly critical for deferred
compensation schemes where it is
desirable that the liability is fully
financed by the employee's investment
at any time.
Introduction of
pension funds
Pension funds along Anglo-Saxon lines
are to be introduced as a fifth financing
vehicle, having the following
characteristics: a separate legal entity,
with external funding, sponsoring DB
or DC plans, no specific investment
restrictions, granting the employees a
direct claim on benefits. It seems likely
that benefits will have to be in the form
of pensions. Employer contributions
(including those financed by salary
deferral, see below) up to 4% of the
social security ceiling remain exempt of
personal income tax and social security
contributions with emerging benefits
being fully taxable; any contributions
over this limit will be taxed up-front. In
all probability, pension funds will fall
under the scope of the Insurance
Supervisory Authority.
What does this mean for employers?
They will offer an attractive alternative
for employer-financed pension plans,
especially for DC arrangements.
However, due to the restriction on
tax-favoured contributions, it will only
be possible to provide appropriate
coverage for incomes up to the social
security ceiling.
Employees' claim on
deferred compensation
In order to provide another attractive
vehicle for private savings, employees
will have a claim on a deferred
compensation arrangement up to 4%
of the social security ceiling as of
January 2002. If the employer agrees to
implement a pension fund or a
Pensionskasse arrangement, this vehicle
is to be used; otherwise, the employee
can insist on the introduction of a
directly insured program. The employee
is free to choose whether to use the
arrangement being offered for salary
deferral or for his tax-favoured savings.
In the latter case, the employee
contributions will in effect be tax-free,
but liable to social security
contributions.
Additional deferred compensation
arrangements, including any where the
deferred amounts exceed the limitation
of 4% of the social security ceiling, are
still possible. Here, any of the now five
financing vehicles can be used, the tax
treatment being dependant on the
financing vehicle: under book-reserved
and support fund arrangements, the
deferred compensation elements remain
tax-free, under direct insurance and
Pensionskassen schemes they continue
to be taxed at a flat-rate up to
DM 3,408 p.a., and under pension fund
and Pensionskassen programs they
remain tax-free up to 4% of the social
security ceiling, in the case of
Pensionskassen, in addition to the
DM 3,408 which are taxed at a flat-rate.
Independent of actual taxation, social
security amounts will have to be paid
on the deferred amounts as of 2009.
The limits of DM 3,408 and 4% of the
social security ceiling refer to the total
of employer and employee financed
contributions.
In future, it will be a legal
requirement that salary deferral
schemes are immediately vested.
Consequently, they are covered by the
mandatory insolvency insurance (PSV)
as of the first day. Also, for
book-reserved deferred compensation
arrangements the calculation rules for
the tax-effective book reserves will be
made more generous. Basically, this will
result in a more balanced local profit
and loss account, with the accrual of
book reserves being similar to the
actual salary deferral.
What does this mean for employers?
Deferred compensation arrangements
will become even more popular and
definitely more widespread. In general,
employers will be obliged to introduce
deferred compensation plans.
When will the
changes come
into force?
The reform is planned to become
effective retroactively as at
January 2001; as far as pension funds
and the claim on deferred
compensation schemes are concerned,
January 2002 will be the effective date.
Most changes will only apply for
pension promises given as of
1 January 2001. Transitional regulations
will apply. This summary is necessarily
a short and incomplete overview of the
way things are developing in Germany.
Changes can be expected when the
final shape of the law is decided, but
multinationals should start thinking
about the impact the reforms will have
for their benefit programs for
employees based in this major
European market.
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Since this article was written, it was
announced on 26 March that talks
between Government and
Opposition had unexpectedly
broken down, and that consequently
the Reform will probably not be
passed by the Intermediate
Committee. The Government is
intending to pursue another
approach to get its legislation
through, by trying to persuade a
sufficient number of State (Länder)
governments of the merits of the
reform to obtain the necessary
majority in the Federal Chamber
(Bundesrat). There is no certainty
that this approach will succeed. A
remarkable situation now exists in
that some parts of the reform, which
did not require the consent of the
Federal Chamber, are in place,
whereas other essential elements are
in suspense.
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For details on an international
discussion group to expand the
issues raised in this article,
refer to the Diary Date page.
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