The German Pension System. An Overview

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1 Established more than 100 years ago the German Pension System often perceived as an old-fashioned dinosaur has been subject to a number of reforms to make it fit for the challenges of the future. The German Pension System An Overview Old-age pensions in the Federal Republic of Germany, Europe s largest economic force with a population of over 80 million people, are still financed by a system established in the 19th century. However, this system, which has provided old-age prosperity for generations of Germans, has undergone massive restructuring measures in the last decade in order to build a strong, sustainable basis for secure retirement.

2 The German pension system is very often perceived as old-fashioned and costly. This perception is mostly due to the Federal Republic of Germany s long tradition of very generous state pension provisions. However, in recent years, Germany has seen ongoing reforms to its pension system in response to both increasing demographic pressure and globalization. The key elements of these reforms can be described as: Dr. Nicolas Rößler, LL.M. Partner, Frankfurt T nroessler@mayerbrown.com a change in the way state pensions are taxed with the introduction of EET taxation ( exempt, exempt, taxed i.e. contributions and investment returns are not taxed, while benefit payments are subject to income tax), strengthening private and occupational pension provision by introducing certified individual retirement contracts ( Altersvorsorgevertrag ), the introduction of pension funds ( Pensionsfonds ) as a fifth financing method for occupational pension schemes ( betriebliche Altersversorgung ), the introduction of a right for each employee to claim to transpose salary entitlements into pension entitlements ( Entgeltumwandlung ), an increase in state pension age, and the reduction of state benefits. The Three Layers of Pensions The German pension system used to be referred to as a three pillars system a system with three pillars that carry the roof, i.e. old-age wealth. After a number of far-reaching reforms, this characterization of the German pension system has faded; the system is nowadays usually viewed as a three layer system, comprising the following elements: Layer I: Basic Provision. This layer consists of the state pension scheme ( gesetzliche Rentenversicherung ), which is still the most important element of the German pension system (covering 82 percent of the work force), and the Ruerup-Pension that was introduced in 2005, a partially tax exempt privately financed pension vehicle. Layer II: Private Provision ( private Altersvorsorge ). This layer is made up of various life insurance contracts or private equity investments. Again, certain tax incentives have been brought in to facilitate participation in this layer, the most important of which is the so-called Riester-Pension. Layer III: Occupational Pension Schemes ( betriebliche Altersversorgung ). The German Pensions Act offers five different financing vehicles, including the (still) most common financing method direct (unfunded) commitments of the employer ( Direktzusage ). In view of the multitude of options covered by Layer II, this paper concentrates on a description of Layers I and III. 2 The German Pension System

3 Basic Provision The State Pension Scheme State Pension Scheme as Part of the Social Security System The state pension scheme is part of the German statutory social security system. As a general rule, under the statutory social security system every employee is obliged to participate in the state pension scheme ( gesetzliche Rentenversicherung ), in an unemployment insurance scheme ( Arbeitslosenversicherung ), in a health insurance scheme ( Krankenversicherung ) and in a nursing care insurance scheme ( Pflegeversicherung ). Contributions to the social security system are borne equally by the employee and the employer. These contributions amount to approximately 40 percent of the employee s gross income up to set contribution ceilings. A Brief History of the State Pension System The German state pension system has a long tradition. It was first introduced by Reich-Chancellor Otto von Bismarck in The system underwent a fundamental reform for the first time in 1957 when the former funded system ( kapitalgedecktes System ) was replaced by a pay-as-you-go (PAYG) financed system ( umlagengedecktes System ). This PAYG system remains the underlying concept of the state pension system today. The basic idea behind it is that the working generation finances retirement benefits for retired workers, through contributions to the state pension scheme, under the so-called generation agreement ( Generationenvertrag ). Over the decades, the PAYG system has needed to be subsidised by other state revenues, such as taxes. In 2001, the contribution income for the German pension system covered only approximately 80 percent of its costs and the remaining 20 percent had to be subsidised. The level of subsidisation required was expected to grow to over 30 percent by 2030 and the necessary contribution rate would have had to be increased from 19.3 to 25 percent of an individual s gross earnings. Therefore, in 2001 a major reform was introduced to the system. General Principles of the State Pension System Obligatory Contributions With Limited Opt-out Possibilities As mentioned above, all participants in the state social security system are obliged to contribute to the state pension scheme. The large number of contributors provides a backbone of the scheme, and is based on the idea of a supportive society. Only civil servants, self-employed people and those employees working in special professions for which special professional schemes have been set up (e.g. lawyers, artists) are either released from, or may opt out of, the state scheme. Level of Contributions Contributions to the state scheme amount to 19.9 percent of a member s gross income. Contributions are born by employer and employee in equal part. Income used to calculate contributions is capped at the social security contribution ceiling (SSCC): in 2010 the SSCC is 66,000 EUR in the old German states and 55,800 EUR in the new German states. mayer brown 3

4 Benefit Types and Benefit Level The state scheme provides for a number of different types of pension benefits, which can be summarised as normal retirement age pensions, early retirement pensions and survivor and disability pension benefits. 1 The state pension scheme was traditionally designed to provide a substitute for the retiree s income. The pension provided under the state scheme alone was meant to allow a pensioner to maintain an adequate standard of living. However, under the reforms mentioned above, benefit levels had to be significantly reduced. The exact amount of benefit naturally depends on the sum of the individual pensioner s contributions to the scheme. The current system is designed to ensure that a standard pensioner ( Eckrentner ) receives an old-age pension benefit amount of about 67 percent of his pensionable income. The standard pensioner is a fictitious person who has paid average contributions to the state scheme for a period of 45 years. The level of benefits is reduced if other types of pension benefits are drawn. In 2010, the average level of benefits for a pension taken at normal retirement age or earlier amounted to approximately 1,000 EUR gross. It is anticipated that the average level of benefits under the state scheme will drop to just above 46 percent of an average employee s final salary before tax by Taxation of State Pension Benefits Before 2005, only investment return earned by the state scheme on the employees contributions was subject to taxation. Since 1 January 2005, state benefits have become subject to EET taxation. This began as a tax on 50 percent of the benefits under the state scheme, and applied to all pensioners who began receiving benefits in 2005 or earlier. The proportion of taxable state pension benefits increases depending on the year in which the pension benefits are drawn for the first time, with a rise of 2 percent per year from 52 percent in 2006, going up to 80 percent by As of 2021, the yearly increase is reduced to 1 percent per year until 2040 (when the entire benefits under the state scheme will become subject to income taxation). 1 Details on the different types of pension benefits (including the eligibility requirements) in English can be found at 4 The German Pension System

5 First Year Taxable Portion First Year Taxable Portion of Benefit Payment of Benefit of Benefit Payment of Benefit until as of Table 1: Development of Taxation of State Benefits The 2007 Reform Introduction of the New Statutory Eligibility Age In 2007, the so-called Statutory Pension Insurance Age Limit Adaptation Act was passed by the German legislator. This Act gradually raises the state pension age from 65 years (as it is now and will be until 2012) to 67 years in the future. Starting in 2012, this increase will be phased in gradually: one month for every year that the employee was born after 1946 (for employees born between 1947 and 1958), and two months for every year that the employee was born after 1958 (for employees born in 1959 or later). Consequently, employees born in 1964 or later will need to work until age 67 to be entitled to the full amount of normal state pension benefits under the new rules. The table next page shows the development of state pension age in the future. mayer brown 5

6 Year of Birth Retirement Year eligibility Age Years + 1 Month Years + 2 Months Years + 3 Months Years + 4 Months Years + 5 Months Years + 6 Months Years + 7 Months Years + 8 Months Years + 9 Months Years + 10 Months Years + 11 Months Years Years + 2 Months Years + 4 Months Years + 6 Months Years + 8 Months Years + 10 Months Years Table 2: Development of Eligibility Age under New Rules As a result, the new rules prolong the period during which contributions are made to the state scheme while shortening the period of benefit payment. Along with other measures, they aim to provide relief for the German pension system. The So-Called Ruerup-Pension Named after Professor Bert Ruerup, the economist who designed this new taxfavoured vehicle, the Ruerup-Pension allows employees to make contributions up to a specified maximum (20,000 EUR p.a.) on a partially tax-free basis to certain licensed funded pension contracts. The Ruerup-Pension is designed to supplement the weakening state benefits. In combination, both pensions ensure that a basic level of pension benefits ( Basisrente ) is provided. The tax-free portion of contributions under the Ruerup-Pension started at 60 percent in 2005 and will rise to 100 percent by Benefits under licensed funded pension contracts must be taken in the form of an annuity after the age of 60. A contract will not qualify as a licensed funded pension contracts if it can be surrendered or borrowed against or if the proceeds can be transferred to the beneficiary s heirs (although a survivor or disability pension can be included). As a retirement savings vehicle that cannot be taken away on bankruptcy, Ruerup-Pension are particularly beneficial for self-employed workers as they provide a high level of security. 6 The German Pension System

7 Occupational Pension Schemes Due to the traditionally strong state provision, occupational pension schemes have long been of minor importance in the German marketplace. However, as the reforms outlined above and increasing demographic pressures have weakened state pension provision, occupational pension schemes have become more popular and increasingly important to avoid old-age poverty. At the end of 2006, 65 percent of all employed workers in Germany were beneficiaries under some kind of occupational pension scheme. However, the average level of contributions was still relatively low. Currently, the assets reserved for funding occupational pension commitments in Germany amount to approximately bn EUR. The market for occupational pension schemes is fast changing and rather immature. Germany has especially been seeing a clear trend moving away from unfunded final salary schemes towards funded money purchase schemes. Occupational Pensions Promising and Changing Occupational Pension Benefits Occupational pensions are promised by employers to their employees. Therefore, the underlying promise is part of the employment relationship and governed by German employment law. Occupational pensions can therefore be promised individually, i.e. as part of the employment contract, or collectively as part of agreements with employee representative bodies (works councils or unions). Once a scheme has been set up, it is very difficult to change its rules with retrospective effect. As a general rule, it can be said that changes that affect future service entitlements are possible if the employer has an objective justification, while changes to past service entitlements require an urgent or important reason. Also, since the schemes rules are part of the relationship between employer and beneficiary, general employment law principles including co-determination rights of works councils must be observed to effectively change a scheme s rules. Final Salary and Hybrid Schemes The German Pensions Act ( Betriebsrentengesetz ) only recognizes final salary or hybrid schemes. Pure money purchase schemes are not admissible under German pensions law. Employers must therefore always promise a defined (or at least definable) level of benefits. Hybrid schemes allow for a promise of contributions, though employers who want to use these schemes must guarantee a minimum benefit level. A typical scheme will include entitlement to a pension at normal retirement age, an early retirement pension option and survivors and disability pensions. mayer brown 7

8 Vesting Subject to deviating contractual arrangements, entitlements vest after five years of pensionable service provided that the employee is at least 30 years of age when he leaves the employer. The scope of the vested rights depends on the scheme structure. In a final salary scheme, a portion of the employee s maximum entitlement vests, which is the equivalent of the portion of the employee s actual years of service (m) in relation to the maximum possible years of service the employee could have served under the scheme (n) the so-called m/n-formula. Under a hybrid scheme, the minimum that employees will receive is an amount equal to the contributions made, along with a possible top-up for investment performance. Financing Methods German pensions law generally recognizes two different methods to finance occupational pension promises: internal financing under a so-called direct commitment, and external financing and indirect commitments. In this scenario, an external funding vehicle is used to finance the promised benefits. The German Pensions Act recognizes four different external funding vehicles: Direct Insurance, Pension Fund, Pensionskasse and Support Fund. Direct Commitment Direct commitments are still the predominant method to finance occupational pension benefits in Germany. Recent statistics published by the German professional association for occupational pensions ( Arbeitsgemeinschaft fuer betriebliche Altersversorgung aba ) show that 53.2 percent of all liabilities under German pension schemes (representing bn EUR of bn EUR) are the result of direct commitment schemes. Under a direct commitment scheme, the employer directly promises to pay the employee a specific benefit amount. The benefits are paid directly by the employer from the employer s cash flow. The employer itself is the sole and exclusive debtor of the pensions benefits. The employer is entitled to accrue book reserves ( Pensionsrueckstellungen ) on its trade and tax balance sheets to mirror its obligations under the direct commitment scheme. These book reserves lower the employer s taxable income and therefore increase its available working capital. 8 The German Pension System

9 However, the tax deductable present value of the employer s liabilities under the direct commitment scheme must be calculated by applying an unrealistically high discount rate, along with other tax law restrictions. For this reason, the accrued book reserves on the tax balance sheet for direct commitment schemes do not reflect the actual value of the employer s pension liabilities, which differs from IAS 19 and SFAS 87 accounting methodology. Benefits under a direct commitment scheme are taxed on an EET basis. The benefit payments are tax deductable as business expenses for the employer. Legal Relationships in a Direct Commitment Pension Promise Beneficiary Employer (legally enforceable claim for employee) Indirect Commitments Legal Framework In the case of an indirect commitment, the sponsoring employer funds its liabilities using an external (third party) financing vehicle. The sponsoring employer may use its own financing vehicle or one operating in the market place. Legally, the indirect commitment consists of a tripartite legal framework between the vehicle, the employer and the employee: the sponsoring employer makes contributions to the vehicle, which in return will directly pay benefits to the employee/beneficiary in case of an insured event. The differences between the four different external vehicles recognized by the German Pension Act can mainly be found in the investment restrictions and tax treatment of the respective vehicles. Direct Insurance Direct insurance consists of an ordinary life insurance contract taken out by the employer on behalf of the employee. The insurance company is the pension provider under such a scheme. The sponsoring employer becomes the insuree while the employee is the insured. The employee, and the employee s survivors, have an irrevocable right to the insurance benefits. Direct insurance provides the same range of choices in the design of a benefit structure as insurance tariffs do in general. The employer is obliged to stand behind the insurance company s capability to pay out the promised pension benefits in case of a pensionable event. If the insurance company is unable to meet its obligations, the employer becomes liable under the pension promise. There is, however, no obligation to accrue pension book reserves for such secondary liabilities. mayer brown 9

10 Contributions to direct insurance contracts are tax-free for the employee up to an amount of 220 EUR per month. All benefits paid by the insurance company that are the result of tax-free contributions are subject to income tax when they are paid out. The employer can deduct any contributions paid under direct insurance contracts as business expenses. In 2009, the assets held by insurance companies under direct insurance contracts amounted to 51.5 bn EUR. Legal Relationships in a Direct Insurance Scheme Insurance Company Direct claim Purchase of pension rights Pays benefits Beneficiary Pension Promise Employer Pension Fund A pension fund is an independent legal entity. It is subject to supervision by the German financial markets regulator ( BaFin ) but has far-reaching freedom as regards its investment possibilities. Pensions funds are set up in the legal form of a mutual insurance association ( VVaG ) or as a public company ( Aktiengesellschaft ). Pension funds can be set up by individual employers, by employer associations or by insurance companies (as a fund open to anyone). On 15 July 2011 there were 29 registered pension funds in Germany. In 2009, assets held by pension funds amounted to just 19.2 bn EUR. This figure is likely to have considerably increased since then, due to the introduction of a higher degree of flexibility in the calculation of contribution amounts. Under a pension fund scheme, beneficiaries can claim pension benefits from the pension fund. Again, the sponsoring employer remains secondarily liable and must step in if the pension fund fails to meet the pension liabilities. The conversion of an existing direct commitment scheme into a pension fund scheme has been encouraged by the German legislator by means of certain tax privileges. An employer that decides to convert its direct commitment scheme into a pension fund scheme can deduct the amount paid to the pension fund to finance the past service entitlements from its taxable profit. These transfer payments to the pension fund have also been exempted from income tax for the 10 The German Pension System

11 beneficiaries, subject to specific prerequisites. Beneficiaries are thereby encouraged to agree to a transfer of their pension entitlements from their employer to the pension fund. Ongoing contributions to pension funds are tax-free for the employee up to an amount of 220 EUR per month. The employer can deduct any contributions paid to the pension fund as business expenses. Benefits paid by the pension fund that are the result of tax-free contributions are subject to income tax when they are paid out. Legal Relationships in a Pension Fund Scheme Employer Pension Commitment Final Salary Promise money Purchase Promise with Guaranteed Minimum Direct Claim Beneficiary Contribution Payments Pension Fund Seperate legal entity Professional investment far-reaching freedom of investment Benefits Payments Pensionskasse A Pensionskasse is an independent legal entity that is subject to supervision by the German financial markets regulator ( BaFin ). It has little freedom of investment and, like schemes offered by insurance companies (Direct Insurances, see above), Pensionskassen may only invest 30 percent of the book value of their assets in equity. Like pension funds, Pensionskassen are either legally structured as a mutual insurance association ( VVaG ) or as a public company ( Aktiengesellschaft ). Pensionskassen are usually set up for one specific employer or for a certain industry. On 15 July 2011, 152 Pensionskassen were registered. The total value of assets held by Pensionskassen in 2009 amounted to bn EUR according to figures recently published by the German professional association for pensions. Contributions to Pensionskassen are tax-free for the employee up to an amount of 220 EUR per month. The employer can also deduct any contributions paid to the Pensionskasse as business expenses. All benefits paid by the Pensionskasse that are the result of tax-free contributions are subject to income tax when they are paid out. mayer brown 11

12 Legal Relationships in a Pensionskasse Scheme Pensionskasse Direct Claim Pays benefits Obligation to pay contribution Beneficiary Pension Promise Employer Support Funds Support funds are independent legal entities that are not subject to supervision by BaFin. They are usually set up as subsidiaries of the sponsoring employer in the legal form of a registered association. Support funds can also be group or industry support funds. In 2009, support funds held a total of 36.8 bn pension assets. Technically, the employer remains the primary debtor of the liabilities and only uses the support fund as a paying agent. Employment case law has, however, established that the beneficiaries can directly claim pension benefits from the support fund. Contributions to support funds are tax deductable for the employer only up to very strict limits. Support funds are therefore usually underfunded. The fund itself is exempt from tax, although it would be liable for corporation tax if overfunded. Given the low tax-free funding level that applies to support funds, these funds often enter into re-insurance contracts to fully fund the employer s obligations. The entire fund may be loaned back to the sponsoring employer at a market-related interest rate. The financial advantages of this credit facility are widely used. However, a loan is permitted only if the security of the pension benefits is not jeopardised. Legal Relationships in a Support Fund Scheme Support Fund Benefits Payment Claim for Benefits under case law principles Contributions Beneficiary Final Salary Promise Sponsoring Employer 12 The German Pension System

13 Contractual Trust Arrangements General Considerations The liabilities for pension commitments that arise under direct commitment schemes (see above) are highly unusual in an international context and qualify as unfunded liabilities under IFRS and US-GAAP. The higher these pension liabilities are, the bigger the concerns and the discomfort they cause in M&A transactions involving multinationals. In extreme cases, unfunded liabilities can even cause the complete cancellation of the transaction, as a bidder running its accounts according to international accounting standards may refuse to take on unfunded liabilities. As international accounting standards have become increasingly relevant (and not just for transactions), a large number of German organizations have been forced to clean out and shorten their balance sheets by getting rid of unfunded liabilities. Further concerns with regard to pension book reserves on the balance sheets of German companies are caused by the rating agencies treatment of them as real debt capital. As a consequence, high pension liabilities cause a bad equity ratio which, especially in the light of the Basel II framework, leads to worse credit conditions. Setting Up a Contractual Trust Arrangement The avoidance of book reserves on the balance sheets can be accomplished by setting-up a Contractual Trust Arrangement (CTA). By establishing a CTA, the employer creates plan assets under both IAS 19 and SFAS 87, which can be netted off against the employer s liabilities under direct commitments and therefore enable the employer to shorten its balance sheet and to eliminate the unwelcome unfunded liabilities. To achieve this objective, the employer transfers assets to a separate legal entity that has been established solely for the purposes of the CTA (the Trust ). This Trust is usually incorporated as a registered association. The assets must be transferred to the Trust irrevocably and expressly assigned to the purpose of funding the sponsoring employer s pension liabilities. The transferred assets must also be completely segregated from the employer s assets to protect these assets against the risk of the employer s insolvency. The employer is entirely free to determine the scope and the kinds of assets that are to be transferred to the Trust and used for funding the pension liabilities. No minimum funding requirements or regular funding obligations apply to CTAs. CTAs are also not subject to any investment restrictions, which makes them a very flexible financing vehicle. Based on a special trust agreement between the employer and the Trust, the Trust acquires legal title in the transferred assets while the economic ownership rests with the employer. This leads to a balance sheet neutrality of the asset transfer for the employer under German GAAP. The Trust s assets remain on the employer s balance sheets. The pension liabilities stay with the employer. mayer brown 13

14 The employer remains the debtor of the pension benefits. At the same time, the pension book reserves that mirror the pension liabilities remain on the employer s balance sheet under German GAAP, but can be netted-off against the assets transferred to the Trust under IAS and US GAAP. A proposed change of German GAAP will allow for such netting off on the German trade balance sheet as well. The trust agreement can provide for the employer s right to be reimbursed for monies paid out to the beneficiaries to meet pension obligations. The set-up of a CTA is not subject to any works council co-determination rights. This is due to the fact that the creation of plan assets does not affect the content of the pension scheme, especially the principles under which the benefits are allocated among the beneficiaries. By creating the CTA, the employer creates additional insolvency protection for the beneficiaries. The employer remains fully obliged under the direct pension commitments. As a result, the virtual transfer of the Pension Liabilities to the Trust does not affect the beneficiaries interests. Legal Structure of a Contractual Trust Arrangement Trust Administrative Trustee Agreement Transfer of Assets Security Measures (Security Trusteeship) Direct Pension Promise/ Pension Entitlements Employer Investment/ Asset Administration Beneficiary Investment Company Market Right to Transpose Salary Entitlements Into Pension Entitlements ( Entgeltumwandlung ) The 2001 reform introduced the individual employee s right to contribute up to 4 percent of his salary, with a maximum of 2,640 EUR, to pension funds, Pensionskassen or direct insurance pursuant to the German Pensions Act ( Betriebsrentengesetz ). Exercising this right would allow the employee to either defer taxation or receive governmental incentives to the extent the employee invests in pension funds, Pensionskassen or direct insurance. Many schemes combine such an arrangement with additional employer contributions, which gives employees additional incentives to make timely arrangements for their retirement. 14 The German Pension System

15 Insolvency Protection The German Pensions Act provides for statutory insolvency protection via a mandatory insolvency protection scheme, the Pensions-Sicherungs-Verein ( PSVaG ). Only certain financing methods are subject to this scheme. Employers that operate direct commitment, Support Fund and Pension Fund schemes are obliged to make contributions to the PSVaG. However, the contribution level for Pension Fund schemes is reduced to 20 percent of the normal level. Direct Insurance schemes and Pensionskassen schemes are subject to supervision by the German insurance supervisory authority and therefore considered protected from insolvency. The PSVaG covers all due benefit entitlements and vested entitlements up to a certain threshold. By operation of law, the PSVaG becomes the debtor of the pension liabilities in case of the employer s insolvency. It may also agree to a settlement agreement between the employer and the employer s debtor in which a comprehensive restructuring plan is agreed. mayer brown 15

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