Germany has built its retirement system on three pillars: Social Security, occupational pensions and individual retirement investments. In this article, we focus on the first two pillars; the third pillar is still relatively small in Germany.
Social Security is a mandatory universal program in Germany and has been the dominant source of retirement income for most workers. It is scheduled, through various past reforms, however, to play a smaller role in the future. The program’s pay-as-you-go finances have already been pressured by a rapidly aging population, unemployment, more years of education and early commencement of retirement; prospects are for more of the same. There are, as yet, no plans for prefunding the program.
Occupational pensions cover about three-fifths of the working population in Germany and have been traditionally designed to fill the gap left by Social Security. With retirement income replacement rates from the public program expected to decline in the future, occupational pensions and individual investments will have to take up the slack. Workers will likely also need to adjust by remaining in the workforce longer.
A public retirement program has existed in Germany since it was established by Otto von Bismarck, the country’s first chancellor, in 1889. Nearly all workers in Germany must contribute to the Social Security retirement program, which also provides survivor and disability benefits. Contributions are assessed on annual earnings up to 63,600 euros (in 2008); the 19.9 percent contribution rate is split evenly between the worker and the employer (low earners pay less). Contributions, however, are paid entirely by the federal government on behalf of the worker for up to three years of child raising, and by long-term care insurance funds if the worker is tending to a relative in considerable need of care.
Although the mandatory contribution rates are scheduled to increase, the government has imposed upper limits of 20 percent through 2020 and 22 percent through 2030. These increases, as well as various benefit cuts described below, are in response to the low birthrate (currently 1.4 births per woman — 2.0 is the population replacement rate without immigration) and increased longevity in Germany that are already straining the finances of this pay-as-you-go program. If all of the reform measures are implemented consistently, the Social Security program should be financed adequately through 2030. Beyond that, however, further benefit cuts and contribution increases may be needed.
Under current rules, a standard old-age pension can be claimed at age 65 if the worker has completed a five-year qualifying period. At that age and after, there is no earnings limit and therefore no pension reductions. Before 65 (assuming the worker is eligible for early retirement), if earnings exceed certain amounts, the pension income in that year is reduced or eliminated. An increase in the pension will result if claiming is postponed, up to age 67.
A worker who has completed a 35-year qualifying period may claim a reduced pension at age 63; the pension is unreduced at this age if the worker is disabled (it is age 60 for certain disabled workers who were 50 before November 2000). A reduced severe disability pension may be claimed at age 60. Unreduced pensions may be claimed by workers born before 1952 if they are unemployed or partially retired, have completed a 15-year qualifying period and are at least age 63 (formerly 60); reduced pensions may be claimed by women born before 1952 at age 60. There are also various pensions paid at earlier ages for those with reduced earning capacity owing to health problems, as well as to widows, widowers, orphans and surviving divorced persons raising children.
Many of these qualifying retirement ages are scheduled to increase. In particular, the minimum age for a standard pension is to be gradually increased from 65 to 67 between 2012 and 2029; the minimum ages for other pensions will mostly increase accordingly. However, some of the resulting steeper actuarial reductions are capped for those claiming disability and reduced earning capacity pensions. Policymakers were concerned that, without the caps, the higher retirement ages would result in reductions too large for these vulnerable groups. To encourage longer working lives, an “exceptionally long service” pension will be introduced beginning in 2012, whereby workers with 45 years of creditable service may claim an unreduced pension at age 65.
The amount of the pension earned depends on the number of years of coverage, the average ratio of the worker’s earnings upon which contributions were paid to average national covered earnings, the type of pension, any actuarial reductions and the “general reference amount.” The latter is the monthly pension that an average earner would receive after paying contributions for one year (26.56 euros in 2008). It is adjusted each year, with the adjustment factor based on trends in the gross income of the country’s active working population, reduced by the current required contribution rate to Social Security and a hypothetical contribution rate to new private pension accounts (described below). As these contribution rates increase, the adjustment factor declines. The general reference amount is now further adjusted (generally downward) by a sustainability factor, to partially take account of the (generally upward) trend in the ratio of pensioners to contributors and the unemployed. The sustainability factor, also found in the Swedish and Japanese programs, under expected demographic trends in Germany will result in lower pensions.
There is a safety clause employed, however, such that the factors curbing pension growth cannot result in the total monthly pension amount ever being adjusted downward, although the cumulative downward adjustment not applied will be offset by halving any pension increases from 2011 onwards until the postponed adjustment is made good. Already due to these several adjustment factors, the attainable net replacement rate for the average worker is expected to decrease from 69 percent to 64 percent in 2008. Further significant declines in replacement rates owing to the cumulative effect of these factors are expected in the future.
Pension plans sponsored by employers are a long-standing feature of the German labor market. Companies such as Krupp and Siemens set up pension plans for their workers in the mid-1800s. More than 17 million Germans currently participate in employer plans. Both defined benefit (DB) and defined contribution (DC) plan types are found, as well as hybrid types, although even DC plans are legally required to have some sort of guarantee to workers, such as return of contributions. Because of this requirement and lesser tax advantages, DC plans are not common in Germany.
Most occupational pensions are DB plans, with both final-average and flat-rate types typical. Benefits can be paid as either an annuity or a lump sum. Sponsoring occupational retirement plans is voluntary for employers, although once the plan exists, the workers’ councils have the right of co-determination for the allocation of benefits.
Under German tax and labor law, plan design is strongly influenced by the funding vehicle chosen by the employer. For example, plans funded by book reserves (explained below) have no limits on contributions or benefits, whereas plans funded by direct insurance have caps on contributions. Similarly, the “pensionskasse” funding vehicle (see below) is usually paired with DC plans with minimum guarantees, whereas book reserves are commonly used for DB and cash balance plans. Most German plans are noncontributory.
The normal retirement age for occupational plans is 65 (it basically corresponds to the standard retirement age in the Social Security retirement program and thus is likely to rise). Often early retirement benefits can be drawn at age 60. Vesting occurs after age 30 and after five years of service; if there is salary deferral, vesting is immediate on deferred amounts. Plans using certain funding vehicles, including book reserves, must pay for insolvency insurance — akin to the Pension Benefit Guaranty Corporation in the United States. Defined benefit plans are usually integrated with Social Security, with lower accruals for earnings below the contribution maximum. Benefit payments are indexed to the lower of price or wage inflation, unless economic reasons prevent this indexation.
Book reserves are the most common funding vehicle in Germany (about three-fifths of total pension assets). It is a method whereby internal company assets are delineated for the pension plan and placed on the balance sheet. Sometimes there are also external assets and reinsurance as part of this approach. This method is tax-favored, as it is not limited in amount and the taxation is only downstream (i.e., upon distribution), and funding is exempt from Social Security contributions. The plan sponsor, however, bears all demographic and investment risks unless reinsured.
The next most common funding vehicle (about a fifth of assets) is the pensionskasse, or autonomous pension fund. This approach involves external funding, conservatively invested; it is comparable to life insurance, although membership is restricted to employees, former employees and their dependents. Because of the relatively high administrative costs of setting up such a fund, it is more commonly used by large companies or groups of small employers banded together. The other funding vehicles include direct insurance and support funds.
German workers have the legal right to divert a part of their earnings (up to 4 percent of the Social Security contribution maximum) to a pensionskasse (if the employer has one) or to direct insurance, as a private pension account. There are no Social Security contributions on this diversion of earnings. Moreover, taxation is downstream. The employer and employees may agree on alternative options, including other funding vehicles as well as more generous maximum limits. In the latter case, however, there are restrictions on the advantaged tax and Social Security treatments.
The pension system in Germany, both Social Security and occupational pensions, is well-developed, complex and long-lived. Nonetheless, demographic and other pressures will cause significant changes to Social Security, reducing benefits to be paid and increasing required contributions. Occupational pensions and personal investments, as well as longer working lives, will have larger roles to perform in assuring retirement income adequacy and security, to fill in the breach for younger and future workers.