From pension reserves to pension funds: An opportunity for the German financial market

Transcription

1 From pension reserves to pension funds: An opportunity for the German financial market In Germany, the tax situation and liquidity considerations make bookreserve schemes the predominant form of occupational pension plan. But these harbour liquidity and financing risks for the companies. Pension funds along Anglo-Saxon lines can help counter these risks. The potential capital market impact is huge. The pension reserves set aside in companies balance sheets between 1982 and 1993 corresponded to the market value of all equity issues by listed German companies during that period. Germany s financial markets would gain in breadth and depth from the investment of pension reserves on the capital market. Legal and tax obstacles stand in the way of a stronger role for pension funds in Germany. That is why fundamental changes need to be made to the regulatory framework along with radical reform of the occupational pension system. Germany s tax regulations differ from standard international practice in many respects. The aim should be to create a level playing field for all types of occupational pension scheme in terms of taxation. It should be possible to transfer existing pension reserves to external funds without this altering the tax position. It would be helpful if the International Accounting Standards were recognized for tax purposes. The use of securities to back pension reserves in the balance sheet (asset funding) is an intermediate step towards external funding via pension funds.

2 Authors: Bettina Nürk, Alexander Schrader Technical assistants: Christa Brauer, Melanie Fladenhofer, Anke Kühnel, Andreas Löschel This publication was completed on January 9, Price: DM 15 (incl. VAT) Further copies may be ordered by fax under the following number: (69)

3 Contents Summary Page I. Introduction 1 II. III. The significance of occupational pension schemes in Germany 3 Direct commitments as an internally funded form of occupational pension scheme 6 1. Outline 6 2. Advantages of direct commitments Tax effects of direct commitments Liquidity and financing effects of pension reserves 7 3. Problems with direct commitments 7 IV. External funding of occupational pension schemes 9 1. Types of scheme and method of financing Support funds Pensionskassen Direct insurance Advantages of external funding Market potential of external funding The limited presence of Pensionskassen in Germany Dominance of state pension insurance Tax reasons Limited use of equities as a form of investment Restrictive investment regulations? Tax obstacles Accounting priciples Equity culture lacking D-Mark strength as a reason for the small proportion of foreign securities 22 V. Implementation The transition Capital resources of companies Asset funding as a step along the road to external financing 25 Appendix: Overview of the investment rules of the VAG 27 List of Abbreviations 29

4 Summary This study seeks to outline a constructive framework for occupational pension schemes in Germany, a framework which would also permit broader funding base for Germany s financial markets. It appears that these goals could be attained by changing to a system in which pension funds along Anglo-Saxon lines play a much greater role than at present. This would require fundamental changes to the legal situation and taxation. Unlike the state pension system, occupational pension schemes in Germany are mainly funded through the accumulation of capital. Estimates put the total amount at DEM bn in Four types of scheme are possible: Pension reserves can be built up in companies balance sheets (56.3% of total accumulated cover in 1993). Funding can be transferred to a Pensionskasse, a Germanstyle pension fund, which acts as external trustee (22.9%). A support fund (Unterstützungskasse) can be set up, also externally (8.7%). Direct insurance, with the company taking out life insurance on the employee s behalf (12.1%). Pension reserves are clearly the predominant form of financing. The reserves formed by Germany s corporate sector harbour huge capital market potential. Those set aside in companies balance sheets between 1982 and 1993, worth DEM bn, corresponded to the market value of all equity issues by listed German companies during that period. What makes book-reserve schemes so attractive is the tax advantages they offer (tax deferrals and tax savings) and the easy access they provide to long-term capital. However, they also entail liquidity and financing risks, especially since pension obligations are often not fully disclosed on company balance sheets. For the economy as a whole, there is a danger that the resources may be used inefficiently and the process of structural change may be held up. One reason why pension funds are so seldom used in company pension plans in Germany is that the tax rules discriminate against them. Where capital is accumulated via pension funds, tax has already to be paid during the contribution phase. With pension reserves, on the other hand, taxation does not kick in until later. This leads to a deferment of tax payments as well as to tax savings for the employee. In addition, payments to a pension fund withdraw liquidity from the company. In other countries, it is not usual for company pension schemes to be based on internal pension reserves. In most cases, such provisions are not recognized for tax purposes. The findings and conclusions reached in this study are summarized in the following points: 1. Empirical evidence shows that in Germany the number of employees covered by an occupational pension I

5 scheme is on the decline. This is mainly due to the considerable cost burden for the companies. Their payment obligations have been raised in the past, while the tax situation and the legal framework have steadily worsened. This trend continues, with an increase in the flat rate of tax on contributions to Pensionskassen and insurance companies from 15% to 20% from January This contradicts the original intention of the government coalition, which was to improve conditions for company pension plans. An improvement is needed if the provision of occupational pensions is not to dwindle further. 2. As a rule, the allocation of assets via the capital market ensures that they are used efficiently. In this respect, external funding of company pension schemes is better than book reserves. An intermediate step along the road to external financing is asset funding, i.e. the use of securities to back pension liabilities on the company s balance sheet. 3. With direct insurance and Pensionskassen, the pension scheme money flows into the capital market, ensuring a broad funding base for the financial centre concerned. However, equities are an investment instrument which is still little used by the Pensionskassen that exist in Germany today. There are several reasons for this: investment regulations are still too restrictive; Pensionkassen are unable to offset the corporation tax credit on dividends; Germany s present accounting standards are an obstacle. But investment in shares would make financial sense for Pensionskassen particularly with a view to enhancing long-term performance. It would benefit both the sponsor company and the insured employee, and it would also strengthen Germany s underdeveloped equity culture. In this respect a further liberalization of the investment regulations to be observed by Pensionskassen and insurance companies would be a constructive move. 4. From the company s point of view, financing its scheme through a Pensionskasse or insurance company has the advantage that the subsequent pension payment obligations do not, as a rule, make any further demands on liquidity. For the employees, it has the advantage that their pensions are freed from the risk of default by the sponsoring firm. Separate management of the cover stock, e.g. by pension funds, encourages competition on performance, measured by benchmarking. Earnings are potentially higher and this ultimately benefits the employees. 5. Fundamental changes to the tax situation would be needed in order to clear the way for a system with pension funds along Anglo-Saxon lines. The tax treatment of contributions to German Pensionskassen or insurance companies, and of the benefits paid out, differs very strongly from standard international practice. Note: Pension reserves do not necessarily lead to inefficient use of capital. But the involvement of the capital market which acts as a control mechanism reduces the risk of capital being allocated inefficiently. II

6 Internationally, no tax is imposed during the phase of capital accumulation. Tax is payable only on the benefits. 6. Legal measures which compel companies to adopt a particular form of funding are unacceptable not least, because they run counter to a market-oriented system. Instead, the aim should be to create a level playing field for all types of employee pension scheme in terms of tax. 7. Regardless of the type of scheme, fiscal recognition of the International Accounting Standards (IAS) is to be recommended when it comes to determining the requisite amount of capital cover. According to the IAS, future trends in wages and pensions are taken into account and an appropriate capital market rate has to be applied as discount rate. After all, the globalization of financial markets demands greater transparency in company financial statements and a closer approximation to international accounting standards. 8. The level of equity at many large German companies should be no obstacle to a transition at least if it takes place gradually from pension reserves to more extensive external funding of pension obligations. The important thing is that this shift should be possible without raising the tax burden for companies (or employees). The transition should not, for example, increase the tax payable on assets. III

7 I. Introduction The question of how, in light of changing demographics, the state pension system in Germany can be financed in future is becoming an ever greater problem in social and economic policy. At the same time, occupational schemes the second pillar of the German old-age pension system have been on the decline for a number of years. The number of employees who have been promised a company pension is falling. The rising costs these schemes inflict on companies are to blame. The increase is largely due to an ongoing deterioration in the tax situation and the legal framework. This trend continues, with an increase in the flat rate of tax on contributions to Pensionskassen and insurance companies from 15% to 20% from January The way things are developing in practice contradicts the original intention of the government coalition. At the start of the current legislative period they had agreed to improve conditions so that company pension plans continue to make an important contribution to the old-age security of the working population. The increase in the flat tax rate mentioned above will also make external funding of occupational pension schemes less attractive compared with book-reserve plans. The latter are already, by a wide margin, the predominant form of employee pension plan in Germany. Pension funds are much less common in Germany than in the Anglo-Saxon countries, for example. This is one of the main reasons why Germany lacks an equity culture. The enormous capital market potential that lies dormant in the pension reserves of German companies is illustrated by the fact that in 1993 these reserves amounted to nearly DEM 260 bn. That was equivalent to almost 33% of the total market capitalization of all listed German companies. Pension reserves set aside in companies balance sheets between 1982 and 1993 corresponded to the market value of all equity issues by listed German companies during that period. This study seeks to outline a constructive framework for occupational pension schemes in Germany, a framework which would also permit broader funding of Germany s financial markets. Having plans managed by external trustees such as pension funds can offer substantial advantages at both micro- and macroeconomic level, provided discriminatory legal and tax treatment does not stand in the way. Chapter II reviews the development of Germany s system of occupational pension schemes and the relative importance of the different types of plan. These are presented in detail in Chapters III and IV. These chapters also examine the reasons why Pensionskassen are relatively rare, and even falling in number, in Germany, and why they do not play the same role in the capital markets, especially the stock market, as, for instance, pension funds in the Occupational pension schemes on the decline Tax situation and legal framework are deteriorating Enormous capital market potential lies dormant in pension reserves 1

8 USA or the UK. The study ends with Chapter V, which discusses questions in connection with the transition to increased external funding of occupational retirement plans via outside trustees, and the conditions that must be fulfilled before such a shift can take place. 2

9 II. The significance of occupational pension schemes in Germany The German system of old-age income security rests on three pillars: 1. The state pension scheme (including civil servants pensions and the supplementary pensions paid to other public-sector employees), 2. occupational pension schemes, and 3. personal provision for retirement income. Pensions provided under the state scheme clearly predominate, accounting for over 70% of total benefits paid in Claims to civil-service pensions formed the second-largest category (over 10%), while the supplementary pensions paid to other public-sector employees were the smallest (barely 3%). The occupational pension schemes set up in the private sector paid out DEM 23.1 bn, which corresponds to a little over 5%. Personal provision through life insurance came to 10% of the total volume. State pensions, civil-service pensions and supplementary public-sector pensions operate on a pay-as-you-go basis, with the present generation of employees paying today s pensioners benefits. By contrast, both personal provision for retirement income through life insurance and occupational pension schemes are mostly funded. In these cases, capital is formed by forgoing consumption during the period in which the rights to a later pension are accrued. The pension is funded with this capital and the income it may generate. The Occupational Pensions Act of 1974 made employee pension plans an integral part of the German social security system. They serve to increase and supplement the basic retirement income provided by the state scheme, and they are also a major element of company welfare policies. To a large extent, companies view them as a means of rewarding employees for long service. As a result, many firms make full use of the ten-year maximum vesting period permitted by law. Under this rule, companies may require employees to work with them for a maximum of ten years before they acquire a non-forfeitable right to a company pension (the employee must also be at least 35 years of age). Otherwise, the right becomes non-forfeitable if at least twelve years have elapsed since the employee joined the firm and if the promise of a pension was valid for at least three years. A distinction can be made between four types of occupational pension scheme, financed in different ways: A direct commitment from the company, backed by the formation of pension reserves on the company s balance sheet. Contributions are transferred to a Pensionskasse, a German-style pension fund, which acts as external trustee. The pillars of old-age income security (Benefits 1993) State pensions Civilservice pensions Life insurance DEM bn Occupational pensions Supplementary publicsector pensions Source: Federal Government's 1993 Social Report; Betr. Altersversorgung, ; German Association of Life Assurance Companies Deutsche Bank Research Four ways of financing occupational pension schemes

10 A support fund (Unterstützungskasse) is set up, also externally. Direct insurance, with the company taking out life insurance on the employee s behalf. The advantages of any one type depend on circumstances at the individual company, not least on the choice of benefit plan. A distinction can be drawn between nominally fixed, defined-benefit (e.g. based on final salary) and defined-contribution schemes. Only with the latter group can the employee be required to bear part of the financing of the company pension plan. Use of the different types of scheme also varies greatly according to the size of the workforce and the sector in which the company operates. The sector patterns are often the result of historical developments. According to a survey carried out by the ifo institute in summer 1993, coverage by company pension plans measured by the proportion of employees at west German industrial companies who had received a preliminary or definitive pension promise fell from 70% in 1990 to 66% in In the west German distributive-trade sector, coverage was down one point to 28% from 29% in In short, the proportion of the working population for whom an occupational pension scheme has been set up is on the decline. The significance of company pension plans for capital formation at macroeconomic level is illustrated by the volume of cover they have accumulated. The table on page 5 gives an indication of the impetus the external capital market could receive if the funds put aside as book reserves were switched into external investments. These impulses are quantified in Chapter IV. 3. The most recently published estimates of Aba (Arbeitsgemeinschaft für betriebliche Altersversorgung), the association for occupational pension schemes, for the volume of cover and its distribution among the different types of pension plan are for They put the total for that year at DEM bn. Just under DEM 260 bn, or 56.3%, related to direct commitments backed by book reserves. Pensionskassen formed the second-largest category, accounting for 22.9%, followed by direct insurance with 12.1% and support funds with 8.7%. Compared with external schemes, book-reserve plans lost ground between 1981 and 1993 even though new reserves were created throughout the period. In 1981 they made up nearly 67% of total cover. By 1993 their share had therefore dropped more than 10 percentage points. Direct insurance registered the strongest growth, increasing its share from 4.9% in 1981 (DEM 10.0 bn) by over 7 percentage points to 12.1% (DEM 55.7 bn) in ). The percentages for Pensions- Use varies according to size of workforce and economic sector Pension reserves are the most commonly used type of scheme and method of funding... 1) However, the figures for direct insurance contain a large element of uncertainty. Since the insurance companies' statistics do not differentiate between direct insurance premiums and other premiums deducted from the employee's pay, and it is almost impossible to draw a clear dividing line between these in practice anyway, the information on the role direct insurance plays in occupational pension schemes can only be taken as a rough guide. 4

11 kassen and support funds also rose slightly. Pensionskassen accounted for 20% of the cover in 1981 compared with 22.9% in 1993 (DEM bn). The figures for support funds were 8.2% in 1981 and 8.7% in 1993 (DEM 40 bn). All in all, there is a visible trend towards external funding of occupational pension schemes.... but there is a visible trend towards external funding Cover for occupational pension schemes in Germany (DEM bn) Pension Pensions- Support Direct Total reserves* kassen funds insurance Source: Aba estimates * According to estimates of Deutsche Bundesbank, pension reserves in industry, distributive trade, and transport came to DEM bn in

12 III. Direct commitments as an internally funded form of occupational pension scheme 1. Outline A direct commitment is a binding promise by the employer to the employee to pay a (retirement) pension when certain conditions are fulfilled, e.g. when the employee reaches a certain age. The employer bears responsibility for the funding. Normally the company will save by forming book reserves during the period of employment the amount which, according to actuarial principles, must be available when the conditions are met, i.e. in this example, when the specified age limit is reached. In case firms should go bankrupt, pension commitments are mutually insured through the Pensions-Sicherungs- Verein auf Gegenseitigkeit (PSV). The PSV then pays the pensions in place of the bankrupt company, though these payments are not inflation adjusted. The PSV is financed almost entirely through premiums paid by the companies which have formed pension reserves or set up a support fund. Over the 20 years the PSV has been in operation, the premium has averaged 1.8, ranging between 0.7 in 1978 and 6.9 in 1982 (following the insolvency of AEG). In 1995 the rate was fixed at Advantages of direct commitments Book reserve plans provide the companies with a valuable source of finance. In relation to total assets, the pension reserves of west German companies in industry, distributive trade and transport rose strongly during the seventies and eighties and came to over 9% in 1987 and The pension reserves on the books of German companies in 1994 were equivalent to almost half the level of equity. One reason why book reserves are so widely used and so attractive is that they enable the companies to defer taxes, an effect that is not achieved with the competing forms of occupational plan. Through pension reserves, companies also have relatively easy access to liquidity. These two aspects are discussed in the following sections Tax effects of direct commitments New rules on the treatment of occupational pension commitments in company accounts came into force under the Balance Sheet Directives Act of Since December 31, 1986, direct commitments have had to be shown as liabilities on the balance sheet. This does not apply to commitments given before January 1, Pension reserves have therefore to be formed for the full amount of new commitments given from the beginning of Since the tax balance sheet must be based on the commercial balance sheet, pension obligations have also to be shown as liabilities in the tax balance sheet. 12 % 9 6 Pension reserves* % of total assets (left) DEM bn Pension reserves (right) * West German companies; industry, distributive trade and transport. Source: Deutsche Bundesbank Deutsche Bank Research Formation of book reserves obligatory only for commitments given since

13 The reserves which are calculated on the basis of actuarial formulae in accordance with tax law must correspond exactly to the present value of future pension benefits at the time pension payments kick in. The main parameters include the so-called biometric probabilities (such as the risk of death or disablement) and the interest rate to be applied. The higher this notional rate of interest, the higher the rate at which future pension obligations are discounted, and the lower their present value and the amount of provisioning in each accounting period. The rate has been gradually raised from 3.5% to 6% (from January 1, 1982; see the German Income Tax Act, Section 6a). Allocations to pension reserves are recognized as taxdeductible expense and reduce taxable profit for the respective period. Once the pension becomes payable, the accrued reserves have to be released gradually, raising profit. Pension payments are a form of operating expense and can therefore be offset against the released accruals. The formation of book reserves enables the company to defer its profits tax liability for a very long period (e.g. 30 years or more). Since pension reserves are, by law, classed as debt, they are deductible when the taxable unit value of business assets is assessed. They are neither business assets nor do they form part of trading capital 2). The fact that these reserves can be deducted for asset-tax purposes saves the company tax compared with alternative sources of funds such as shareholders equity or other types of debt (loans etc.). With pension reserve schemes unlike contributions to Pensionskassen and life insurance companies (see IV.4.2.) the necessary capital accumulates tax free Liquidity and financing effects of pension reserves By forming pension reserves the company is able to retain liquidity which would otherwise go to external trustees. This self-financing effect is greatest at the start of the scheme. As time passes and the first benefits are paid, it decreases. Total liquidity is not actually reduced unless the disbursement to service the pension claims exceeds the allocation to the reserves. The financing available from pension reserves is advantageous for the company also in that it does not entail any disclosure obligations or an examination of creditworthiness, nor can pension reserves be called. Profits tax: deferral Assets taxes: savings Capital accumulates tax free Easy access to liquidity 3. Problems with direct commitments Pension schemes are a substantial cost factor for companies. Occupational pensions now account for nearly one fifth of total ancillary personnel costs (i.e. collectively bargained and company-specific items). It is therefore essential that pension obligations be financed efficiently 2) If partnerships form pension reserves for managing partners, however, these must be included in the capital on which trade tax is based. 7

14 and predictably. The system of direct commitments backed by book reserves no longer meets these requirements. The inadequate reflection of future pension obligations in many companies balance sheets gives rise to a liquidity risk which should not be underestimated, especially for smaller firms. When a company forms pension reserves, no external control mechanism ensures that the funds are used in the most efficient way. Whether efficient or inefficient, companies can, by setting aside reserves, retain liquidity and withhold it from the capital market. But this does not provide any gains for the economy as a whole. A healthy, profitable company can raise the funds it needs for investment projects in the capital market at any time at normal market conditions. When turning to the capital market, a company will check whether the return it can obtain on internal investment really is higher than the market yield, making it worthwhile to invest in the company. Self-financing through pension reserves, on the other hand, allows companies to pursue loss-making investments and strategies which may be justified only if profits and losses can be offset internally. This preserves inefficient company structures and hampers structural evolution in the economy. Liquidity risks Possible inefficiencies at the macroeconomic level 8

15 IV. External funding of occupational pension schemes One approach which would appear helpful in solving the problems related to pension reserves as identified in Chapter III.3. is increased recourse to external capital formation e.g. through pension funds. The following sections look at the different forms of externally funded occupational pension scheme and their advantages from both a microeconomic and a macroeconomic standpoint. They also contain examples illustrating the potential capital market volume attainable through external financing. 1. Types of scheme and method of financing Externally funded occupational pension schemes require the services of an outside trustee. In Germany, this can be a support fund (Unterstützungskasse), a Pensionskasse or an insurance company Support funds Support funds are legally independent pension institutions which usually exist in the form of an eingetragener Verein (registered association) or a GmbH (private limited company). The sponsor can be a single business or several companies jointly. Contributions must be paid by the employer alone. The employer himself decides at what intervals he pays his contributions. If his earnings situation is unfavourable he can refrain from transferring funds or reduce his allocation. No one has a legal claim to benefits from a support fund (although the Federal Court of Labour has meanwhile largely abolished the exclusion of a legal claim). This means that companies are not released from liability for the obligations of the support fund, so these pension commitments also have to be insured with the PSV. Company allocations to the fund are deductible as operating costs. The benefits paid out later by the fund have to be declared as taxable income by the recipient (after deducting a basic allowance). No tax burden is incurred in the period during which the rights to a later pension are accrued. Because they are considered social institutions, support funds are under certain conditions exempt from corporation tax, property tax and trade tax. This is also the reason that the workforce or the staff council of the sponsor company has a say in their management. One prerequisite for tax exemption, among others, is that the assets held in the fund do not exceed an amount specified in Section 4d of the Income Tax Act by more than 25%. Otherwise, the support fund is required to pay tax on the excess. Owing to the formal exclusion of a right to benefits, support funds are subject to no investment directives from a regulatory authority, i.e. they can invest their monies without restriction. This also means there are no limitations Contributions to support funds paid by employer alone No tax incurred during the pension accrual period 9

16 on returning funds to sponsor companies as loans. Apart from investment in real estate, lending back to the sponsor is the most important form of investment for support funds. Investing in the capital market plays an insignificant role. A support fund is usually unable to provide full capital cover for pension commitments since company allocations are recognized for tax purposes only until the assets accumulated cover two annual pensions per prospective beneficiary. The funds can (partially) offset this disadvantage by investing in real estate since property is entered in the balance sheet at the assessment value and thus has a much lower book value than its actual market value. It remains to be seen whether Germany s constitutional court ruling on the taxable unit value of assets will impact this practice. Since pre-financing via support funds has tax limitations, some companies have also set up covered support funds (by reinsuring a support fund with a Pensionskasse or a life insurance company). There were 5,163 support funds in Germany in Of these, 1,641 were pure support funds, i.e. the support fund was the sole form of occupational pension scheme used by the sponsor company Pensionskassen Pensionskassen (German-style pension funds) are also legally independent institutions for retirement benefits. As with support funds, the sponsor can be a single business or several companies which are either independent or belong to the same corporate group. Unlike support funds, contributions can be made jointly by employers and employees. Companies can deduct the allocations as operating costs for tax purposes. In contrast to support funds, Pensionskassen grant pensioners a legal claim to their benefits. As a mutual benefit association, the funds fall under the supervision of the insurance authority, so the provisions of the Insurance Supervision Act (Versicherungsaufsichtsgesetz - VAG) apply to their capital resources and investment behaviour. Loans to the sponsor company or companies are possible to an only limited degree. Therefore, investing in the capital market plays a much bigger role for Pensionskassen than for support funds. There were 150 Pensionskassen in Germany in 1993 under the supervision of the Federal Supervisory Office for Insurance Companies (Bundesaufsichtsamt für das Versicherungswesen) 3). Their number has been on the decline for years (1990: 168), while the funds overall capital investment and total assets have risen. Transfers to the Pensionskassen are usually set as a percentage of the wages liable for contributions. The rate Loans and real estate are the most important forms of investment for support funds Tax structure limits prefinancing via support funds Pensionskassen under supervision of insurance authority Number of Pensionskassen on the decline 3) There are also serveral other small Pensionskassen under the supervision of the Länder governments. In 1993, the total was

17 can apply equally to all members insured, or vary according to age. Premiums must be fixed in such a way that the Pensionskasse/insurance company can form the necessary cover capital. The maximum notional rate of return which German Pensionskassen and insurance companies are currently allowed to apply is 4% (before the VAG amendment on July 29, 1994: 3.5%). Since the employee acquires a legal claim vis-à-vis the Pensionskassen, the employer s contribution is treated as part of his taxable wages (the employee s portion comes from after-tax income). The tax is usually paid by the employer. In this case a flat rate can be applied, which from 1996 is 20% up to a maximum contribution of DEM 3,400. 4) This rate does not, however, contain the solidarity surcharge and church tax. On contributions above this amount, the employee s individual tax rate is applied. When the benefits are drawn, the pensioner must pay tax only on the income accrued, i.e. on the interest earned on the invested funds. Traditionally, Pensionskassen have always been considered social institutions. They are therefore exempt in principle from corporation tax, trade tax and property tax. This is only true if pension fund assets do not exceed an amount defined in Section 5 (1) 3 (d) of the Corporation Tax Law (KStG) (i.e. the pension fund assets must not exceed loss provisions). Furthermore, as social institutions, the Pensionskassen are subject to co-determination, usually on the basis of (full) parity of representation. So far, this is found primarily at management board level since most Pensionskassen still have no supervisory board. However, the VAG amendment raised the standard of qualification required of management. This new arrangement will probably result in a general shifting of co-determination from the executive board to the if need be, still to be established supervisory board Direct insurance With direct insurance an employer takes out individual policies or a group policy with a life insurance company on behalf of his employees. In a so-called Gehaltsumwandlungsversicherung, the insurance premiums are paid by the employee alone. Pure direct insurances and insurance policies based on employee deductions are, however, not reported separately in insurance company statistics. Like with the Pensionskassen, contributions to direct insurance can be split between employer and employee. The funds allocated by the employer are to be treated as taxable income under the same conditions as apply to Pensionskassen, and they can also be considered operating expense which reduces profit. The pensioner is liable for tax on future benefits only with respect to the share related to accrued income. Naturally, the VAG regulations apply to Employer contributions subject to income tax As social institutions, Pensionskassen are in principle exempt from tax and subject to codetermination Pure direct insurance and insurance premiums deducted from wages not reported separately in the statistics 4) A 15% flat rate on a maximum DEM 3,000 applied until the end of

18 insurance companies in the same way as they do to Pensionskassen. 5) 2. Advantages of external funding From a microeconomic standpoint, external types of pension scheme and methods of funding offer the advantage that the company can minimize the liquidity risk related to its obligation to render benefits to the pensioner. 6) Therefore, above all smaller companies decide to form (group) Pensionskassen 7) or take out direct insurance on behalf of their workforce. The risk that they might have to shoulder the responsibility for pension benefits after all although so far this has never happened could be reduced further in the case of Pensionskassen, if the latter were allowed to increase their assets to more than the volume permitted by Section 5 (1) 3 of the KStG. This could play a role when a fund s investment generates a very high return. If the excess assets were not (as currently) subject to taxation, the Pensionskassen could themselves smooth over fluctuations in earnings performance by building up a liquidity cushion. Given a very good investment performance, the contributions paid by companies and the insured could be (temporarily) reduced. A basic condition for tax exemptions for excess assets of a pension fund would, however, have to be that the assets are used exclusively in the interests of company social policy and thus to the benefit of the members covered by the fund. Moreover, setting up group Pensionskassen gives smaller companies in particular the opportunity to reduce administrative costs through outsourcing. In addition, with Pensionskassen and insurance companies, companies are able to include the workforce in the financing of retirement benefits. This advantage continues to gain significance above all in view of the growing costs to companies of occupational pension schemes. Another possible advantage is that employees take more interest in and have greater appreciation of the retirement plan if they themselves are involved in the financing. Gearing the scope of the pension commitments to earnings performance might also help. From a macroeconomic standpoint external funds have the advantage that their investments can be diversified among different instruments, projects and countries. Earnings risks are reduced and opportunities exploited fully. Turning to the capital market allows efficient fund allocation and limits the danger of capital being invested Minimization of liquidity risk Ability to include the workforce in the financing and reduce costs Diversification and efficient fund allocation 5) Therefore, they are usually not required to insure against insolvency with the PSV. 6) This does not apply to a support fund, as the sponsor company is liable for the former s commitments. With Pensionskassen there is the possibility to rule out a subsidiary liability of the sponsor company in the articles of association (in agreement with the Federal Supervisory Office). However, if the fund is unable to adjust pension benefits to match purchasing power as prescribed by labour law the sponsor is required to step in. So far, though, the excess returns generated by the funds have always sufficed to cover the adjustments. 7) As a rule, group Pensionskassen are set up for several companies of the same sector, but they can also be designed to cover more than one sector. 12

19 unwisely. By selecting promising investments and companies the risk is lowered that outdated, unprofitable corporate or production structures are preserved. In addition, the bond and equity markets stand to gain breadth and depth on the demand side through the external investment of occupational pension schemes funds. At the same time, financing via the capital market becomes more attractive owing to reduced flotation costs (higher securities prices on rising demand). Hence, this will also increase the supply of securities. Furthermore, external forms of funding provide a better framework for dismantling the obstacles to mobility which the statutory ten-year maximum vesting period can create. Workforce mobility and flexibility are considered key factors for the competitiveness of the German economy today. With Pensionskassen it is relatively easy to have pension claims transferred from one company to another when switching jobs, which is also an advantage from the employee s viewpoint. For example, with group pension plans, it is possible to change jobs among the individual member companies without having to waive any accrued pension claims. Moreover, some Pensionskassen in Germany, such as the BVV Versicherungsverein des Bankgewerbes a.g., give every employee the right at the start of his employment with a member company to extend his insurance policy on a voluntary basis if he moves on to a non-member company. Direct insurances also offer the possibility of voluntary extension of a policy at the employee s expense, but this requires the employer s approval. 8) Still with regard to the employee, funding via an external trustee such as a Pensionskasse offers the theoretical advantage (not used so far in Germany) that the insured party can be given an option to choose between different portfolio alternatives. For example, some US companies give their employees the opportunity to select a plan from several pension funds offering alternative risk and earnings profiles. The insured can base their selection on their individual risk preferences. The funds thus compete along market lines on the basis of earnings performance to win the right to invest the assets of the sponsor companies employees. External management by separate institutions is the prerequisite for benchmarking, i.e. the insured are able to judge the performance of the investment by comparing with a standard yardstick. Broad funding base for the capital market Dismantling of obstacles to mobility Scope for performance competition and benchmarking 3. Market potential of external funding The following quantifies the market potential which would emerge by shifting the capital accumulated in the 8) Even reserve-financed direct commitments allow arrangements which make it easier to transfer claims from one company to another. For example, a member company of the Bochum Verband usually has to recognize the service years of an employee listed with the Verband which were spent at another member company. However, there is no formal requirement to do so. In the same way, already formed pension reserves can only be transferred between member companies of the Verband if both companies agree to do so. 13

20 past as book reserves into outside funds. Three scenarios, which relate to the degree of externalization, are played out. Radical solution: externalization of all pension reserves If all the capital cover for occupational retirement schemes formed through book reserves at German companies were externalized, that would create additional capital market potential of close to DEM 260 bn (1993 figures). This corresponds to nearly 33% of the market capitalization of German public limited companies in Such a shift would trigger a substantial need for additional equity and debt capital in the corporate sector. Gradual externalization of pension reserves If all the book reserves formed on balance between 1982 and 1993 had been accumulated in an external Pensionskasse and invested in the market, this would have given an additional stimulus of DEM bn to the capital market for this period. For comparison, pension reserves set aside in companies balance sheets between 1982 and 1993 corresponded to the market value of all equity issues by listed German companies during that period. If these newly formed book reserves had in actual fact been transferred outside the company, the share of funds not reported as pension reserves and thus potentially available to the capital market would already have accounted for a good 70% of total cover capital in This compares with the just under 44% actually posted. The scenario of a gradual transfer for cover capital to be formed in future appears the best suited to allow a gradual turn to external forms of funding. This transition will be discussed in greater detail in Chapter V.1. Market potential of close to DEM 260 bn with full externalization of book reserves Potential stimulus of DEM bn to capital market through externalization from 1982 Conversion of the pension system There is currently no sign that Pensionskassen in Germany will be able to attain the same importance as pension funds in the United States or the United Kingdom. This would require that much of the financing for Germany s state pension system (including the pensions for the civil service) be converted to a capital-cover basis. In 1994, the ratio of pension fund assets to gross domestic product (GDP) came to 56.6% in the USA, and 76.5% in the UK. If the US reading were transposed to Germany, this would give an asset pool of close to DEM 1,900 bn for the same period, equalling nearly two-and-ahalf times the market capitalization of German public limited companies in that year. Naturally, such calculations are only relevant with substantial reservations. The American and British state pension systems play a relatively smaller part than the German system in comparison with the private and corporate schemes, much of whose cover capital is managed by external trustees. 14

21 4. The limited presence of Pensionskassen in Germany The table on page 5 shows that Pensionskassen rank second as a form of financing occupational pension schemes in Germany and in terms of the cover capital accumulated are by far the most significant type of external trustee. They are the focal point in the following discussion. This appears justified since support funds lack certain key features which, in our opinion, must be present in order to speak of genuine external funding of occupational schemes. These include: The liquidity is entirely withdrawn from the company, i.e. the cover capital earmarked for a corporate pension scheme is removed from the company s disposition and deposited, in the main 9), with external funds; Future benefits are fully pre-financed, which with support funds is only possible through full backing by a Pensionskasse or an insurance company, but not with such a fund alone; Allocations to the external trustee are made at regular, previously agreed intervals in amounts which cannot be determined arbitrarily by the sponsor company. This is the only way to build a corporate pension scheme steadily in the long term. The table and the chart on this page illustrate the scale of the pension fund assets accumulated in selected OECD countries as well as their distribution within the EU. 10) What emerges is that the significance of pension funds varies substantially from one country to the next. In the EU, asset management by pension fund is confined mainly to the UK and the Netherlands. Pensionskassen tend to play a minor role in Germany compared with these countries and the USA and Japan. Different reasons are at play Dominance of state pension insurance One major reason for the limited presence of Pensionskassen in Germany is the dominance of state pension insurance in Germany s old-age security system, which is financed on a pay-as-you-go basis. Pension funds play a small role in several other countries such as France or Italy for the same reason. Germany has meanwhile seen a few attempts to fund pension commitments to civil servants at least partially by the formation of cover capital. For example, the state of Support funds not a genuine form of external funding Pension fund assets in selected OECD countries, 1994 Total USD bn % of GDP United States Japan UK Netherlands Switzerland Germany France Ireland Belgium Source: InterSEC Research Corp., Stamford Deutsche Bank Research The EU market for pension funds* UK 59.6% Total: USD 1,203 bn Source: Pragma Consulting NV/SA * in terms of assets in 1993 NETH 22.0% BEL 0.6% Southern Europe 2.2% GER 8.8% DEN 2.2% FRA 3.4% IRE 1.5% Deutsche Bank Research 9) Some Pensionskasse/insurance company funds can be made availabe to the sponsor company in the form of corporate holdings or loans; however, this must be in compliance with the investment regulations laid down by the VAG (see appendix). 10) The 1994 figures for Germany include not only the Pensionskassen but also the support funds. Moreover, it must be borne in mind that depending on the definition international statistics may also consider as pension (fund) assets funds which do not serve as capital cover. The USD 124 bn cited for Germany also include the capital investment of the Versorgungsanstalt des Bundes und der Länder (VBL), which is financed by a modified pay-as-you-go procedure (capital investment in 1993 approx. DEM 14 bn). 15

22 Schleswig-Holstein has already allocated the initial instalment for a pension fund. Rhineland-Palatinate intends to establish a pension fund for newly hired civil servants in autumn However, neither of the two states has so far attempted to find a long-term solution to ensure complete cover for pension commitments Tax reasons Given the current tax legislation in Germany, book reserves represent a better alternative particularly from the employee s standpoint than Pensionskassen. When pensions are funded via Pensionskassen the Tax Office lays claim to a portion of the employer contributions, deeming them wage income in the period during which pension rights are accrued. The employer usually pays the tax at a flat rate. The employee pays his contributions from after-tax income. In contrast, employer expenditures for direct commitments (formation of book reserves) and support funds are not subject to income tax. A tax debt arises for the pensioner only when the benefits are actually disbursed. 40% of the pension payments (maximum of DEM 6,000 in the tax period) is, however, free of income tax. This practice of benefits-only taxation thus has the advantage not only of a substantial tax deferral for the employee, but also often results in an ultimate tax saving. This holds especially if the beneficiary s tax situation differs from during the contribution period (say, for example, if his tax rate has fallen because his income is lower as a whole, or thanks to age relief). Considering the interest rate advantages achieved by deferring the tax, his tax burden will always be reduced de facto. Unlike normal practice in Germany, other countries usually refrain from taxing contributions to pension funds, i.e. no tax is incurred in the accrual phase. The benefits are, by contrast, taxable. 11) Like in Germany, company contributions to pension funds (or similar trustees) are deductible as operating expense. Frequently, the employee s contributions can also be deducted for tax purposes. In Germany, the tax conditions for Pensionskassen and insurance companies have deteriorated seriously with the increase in the flat rate on allocations to managed pension schemes from 15% to 20%. Factoring in the solidarity surcharge the rate has risen to 21.5%; including the church tax, to even more than 23%. 5. Limited use of equities as a form of investment Pensionskassen in Germany cannot wield the same influence on the equity markets as pension funds in the USA or UK, if only because they are smaller in number (cf. adjacent table). Moreover, German Pensionskassen are generally somewhat reluctant to invest in stocks, as witnessed by the small proportion of shares in their portfolios 11) In some countries, though, the earnings portion is also exempt from tax. Taxation in the pension accrual phase Tax regulations contradict standard international practice Distribution of share ownership in % (1990) USA UK Germany All companies Financial institutions Banks Insurance companies 4.6 Pension funds Other 5.7} } Non-financial companies Households Non-residents Government Sources: Stephen Prowse: Corporate governance in an international perspective, BIS Economic Papers, No 41 - July Deutsche Bank Research 16