Occupational pensions

in Germany:
Time for action

Rüdiger Blaich
Table of contents
Introduction 1
1 Pensions in Germany 2
2001-2009 reforms – an increased role for private pensions 2
2 An unsustainable system 4
3 The need for occupational pensions  7
Defined Benefit plans in decline 7
Salary conversion: new impetus for corporate pension provision 7
Executive pensions on the rise  8
4 Stimulating occupational pensions – a moral imperative? 9
A new deal between unions and employers? 9
Becoming an employer of choice  10
5 Communication is key 11
Educating and encouraging employees 12
6 The rise of external financing vehicles 13
The rise of pension funds and CTAs  13
Book reserved plans – a model in decline  15
Time to derisk? 16
BilMoG – making pension liabilities more transparent 16
Derisking pensions 17
7 Building sustainable pensions – eight guidelines  18
8 Time to act 19
Acknowledgements 20
References and notes 21
Introduction
Say ‘Die Rente ist sicher’ (‘The state pension is safe’) and most Germans over the age of 40 will
immediately recall Norbert Blüm, Helmut Kohl’s labour minister (1982-1998). During a highly publicised
campaign event in 1986, Blüm hung a poster in the market square in Bonn that read, ‘And one thing
is for sure – the state pension.’

More than 20 years later, Blüm’s statement is still frequently quoted in the German media in debates
about pensions and pension reform. Unfortunately, it appears to have convinced many ordinary
Germans that all is well with their pension and that no further action needs to be taken. That would
be a mistake. Despite some important reforms over the last 10 years, the level of pension people will
receive from the state will continue to decline.

Given this increasing decline in state pensions, employers will play a key – and growing – role in
strengthening the overall system. This is not a case of pure altruism on the part of companies. By
offering employees a supplementary pension, they can better attract and retain employees.

For those companies already offering pensions, the introduction of new German accounting rules
this year has led many companies to look at solutions to help them to strengthen both their pension
provision and their overall financial position. These solutions include pension derisking and liability
driven investment solutions.

In this paper, we discuss why occupational pensions in Germany are not yet as fully developed as they
could – and should – be. We’ll also address why multinational companies with operations in Germany
should take another look at their pensions.

“Germany is not unique in facing serious challenges with its pensions, but the German pension
system itself is unique and requires different solutions compared to other countries.”

1
 1 Pensions in Germany
In 1889, Germany introduced the world’s first state pension system. Germany’s system, designed
originally by the Chancellor Bismarck, has survived two world wars, currency reforms and periods
of hyperinflation. Originally, Germany’s state system was a funded system, but, in 1957, in order to
remove inflation risk, it was converted into a pay-as-you-go (wealth transfer) system.

Until today, thanks to Bismarck, German pensioners have been able to enjoy relative prosperity. From
the beginning, the state pension system was designed to enable pensioners to continue to enjoy
the same standard of living to which they were accustomed during their working life. For decades,
the contribution rate for pensions has been adjusted in order to provide a replacement rate of
approximately 70% of final average earnings. Pensions have also been indexed to gross (and later
net) wages in order to allow pensioners to participate in the country’s growing prosperity.

But that prosperity has come at a price. Pensions are now the single largest item in the German budget.
Germany spends 11.4% of its GDP on pensions compared with 7.2% in the OECD as a whole. The price is
also high for individuals and employers. Today, every employee subject to the statutory social security
system pays 19.9% of gross salary into the pension insurance system (Deutsche Rentenversicherung),
which covers retirement, survivors’ pensions and disability cover. Contributions are paid up to a social
security ceiling (currently €66,000 in the West and €55,000 in the East). The total social security
system takes more than 41% of an employee’s income and is split approximately 50/50 by employer
and employee. Understandably, companies are keen to prevent further rises in the contribution rate
in order to keep non-labour costs in check and prevent the erosion of competitiveness.

Although occupational pensions presently play a minor role in Germany, they enjoy a long tradition.
German companies have long demonstrated their social responsibility toward their employees and
taken the initiative to provide them with an extra pension. Already in 1850, large industrial companies
such as Bosch, KRUPP and Siemens were offering employee benefits.

Germany has one of the most rapidly aging populations in the developed world. According to the
Federal Statistical Office, the proportion of the population aged 65 and over in comparison to the
working age population will more than double from 24% in 2009 to 50% in 2050. This poses some
serious financial problems for all stakeholders. As a result, the German government has started
implementing reforms to address this increasingly urgent issue.

2001-2009 reforms – an increased role for private pensions

With the reforms of 2001 and 2005, the German government attempted to put the pensions system
on a more stable footing. The main objective of the 2001 reform (‘Act on Assets for Old Age’) was to
prevent an excessive burden on current and future generations by stabilizing the contribution rate
into the state system to 20% of gross wages until 2020 and 22% until 2030. This was achieved by
reducing the replacement rate from 70% to 67%. To make up for the gap, the government created
incentives to save additionally through state–subsidized private pension products (called ‘Riester-
Rente’ products). The introduction of state-subsidized private retirement savings products was a first
for Germany.

2
The Retirement Income Act of 2005 introduced deferred taxation on pension income, with tax relief on
some contributions and taxation on benefits. This aligned Germany to the European and international
norm.

The most recent reform, in 2009, has been the increase in the retirement age from 65 to 67, to be
implemented gradually, starting in 2012 and taking full effect in 2029.

Key elements of 2001 reform:

• A basic minimum pension was introduced.

• The pension fund was introduced as a new financing vehicle.
• Employees earned the legal right to set aside part of their gross earnings toward an employer-
sponsored retirement plan.
• The portability of occupational pensions improved.

Key elements of 2005 reform

• Tax relief for capital life insurance was abolished for new contracts.
• The so-called ‘sustainability factor’ was introduced. This adjusts the pension level depending.
on a number of factors, including longevity and the number of contributors in the system.
• Contributions toward third-pillar retirement savings became exempt from tax, beginning with
€12,000 per year in 2005 and growing to a maximum of €20,000 of tax relief per year by
2025.
• The proportion of pension income subject to tax will depend on the year of retirement. In
2005, 50% of pension income was subject to income tax. The tax rate will increase 2% each
year, so that, by 2040, 100% of pension income will be taxed.
• The flat tax rate of 20% that employers used to pay for contributions into a direct insurance
contract was abolished (for new pension promises).
• The portability of and vesting rights for occupational pensions was improved.

3
 2 An unsustainable system
The German reforms have clearly had an impact. Private pension savings (the third pillar) have
increased and the number of people enrolled in an employer-sponsored retirement plan has grown
(from 38% of all private-sector employees in 2001 to 51% in 2007). This is mainly because employees
now have the legal right to convert part of their salary into a pension premium, and because of
better vesting rights and the improved portability of occupational pensions. Nevertheless, 80% of
all occupational pension plans are still financed entirely or partly by the employer, according to the
central Federation of Employers’ Associations (BDA).

However, despite the positive effect of the latest pension reforms, they will not be enough to ensure a
comfortable standard of living in retirement for today’s workers. This is not widely understood by the
broader population. People are investing too little, too late.

While state benefits will remain the main source of income in retirement for some time (currently
accounting for around 80% of a German’s retirement income), many people do not know that the 2001
67% replacement rate for the state pension is based on a hypothetical pensioner who has paid into
the system for 45 years without interruption. Few people fit that mould today, due to longer periods
of tertiary education, fragmented job histories, more short-term contracts, low-paid traineeships,
periods of freelance work, time spent raising children or caring for an ill family member, etc. The
pension level of higher earners (defined as those earning above the statutory social security ceiling
of €66,000 in western Germany) will be even lower.

The ‘sustainability factor’ introduced as part of the reforms of 2005 will almost inevitably lead to a
further substantial reduction in benefits in the future, although the government has stipulated that
the pension replacement rate (for someone who has worked for 45 years uninterrupted) should not
fall below 43%. The sustainability factor enables the state to limit the burden of providing pensions
but it also considerably increases the risk that individuals will not receive the pension that they think
they will receive.

Figure 1: Old-age provision from state system for normal earner for different retirement ages

� 25.000
� 22.522

� 22.522

� 22.522

� 20.000

� 15.000
57%
51% Net annual income
45%
� 12.928

Net pension
� 10.000
� 11.487
� 10.126

� 5.000

�0
Age 63 Age 65 Age 67
Source: Towers Watson

4
To illustrate the potential pension gaps, Towers Watson has calculated that a 45-year old average
earner with a gross annual salary of €30,000 (€22,522 after taxes) will receive 51% of their last gross
salary if retiring at age 65. This will be barely enough to cover basic living costs.

While the standard of living in retirement need not be the same as during one’s active working life,
costs will increase for many retirees. Young retirees tend to spend more money on hobbies and travel,
while older retirees may need more services and financial resources for medical care.

The unsustainability of the German system is even more evident when seen within a European context.
Recent research on the ‘pension gap’ per person across Europe (defined as the difference between
the income needed to live comfortably and the actual income individuals can currently expect to
receive at retirement) has shown that the pension gap is presently the highest in the United Kingdom,
followed by Germany in second place. A German retiring between 2011 and 2051 would have to start
now saving €11,600 extra a year in order to have a comfortable retirement income, according to their
calculations.

Figure 2: The Pension Gap for individuals

Average annual pensions gap per person for individual retiring 2011 – 2051 (€)

14

12 12.3
11.6
10
€ thousands per annum

9.1
8
7.9
7.0
6

4 4.6
3.7
3.1 3.4
3.0
2
1.9

0
HU LT IT PL RO CZ ES FR IE DE UK

Source: Aviva Europe/Deloitte

Mercer provides another perspective of Germany’s pension problem. In 2009, it compared 11 countries
based on three criteria:
• Adequacy (level of benefits, tax support, benefit design, the degree to which high levels of saving
are encouraged, etc.)
• Sustainability (coverage of employees in private system, assets/funding, government debt, etc.)
• Integrity (pension governance, prudential regulation, communication, etc.).

5
 These indicators were combined to arrive at an overall ‘grade’ from A to E, with A the best score.
Germany received a ‘D’, putting it at the bottom of the list. A ‘D’ grade indicates that the pension
system has major omissions or weaknesses. One of the weaknesses identified for Germany was its
strong reliance on the book reserve system.

Figure 3: Mercer Global Pension Index

Grade Index value Countries Description

A first class and robust retirement income system that
A >80 Nil delivers good benefits, its sustainable and has a high level
of integrity.
A system that has a sound structure, with many good
Netherlands, Australia,
B 65-80 features, but has some areas for improvement that
Sweden, Canada
differentiate it from an A-grade system.
A system that has some good features, but also has
major risks and/or shortcomings that should be adressed.
C 50-65 UK, USA, Chile, Singapore
Without these improvements, its efficacy a and/or long-
term sustainability can be questioned.
A system that has some desirable features, but also has
major weaknesses and/or omissions that need to be
D 35-50 Germany, China, Japan
adressed. Without these improvements, its efficacy and
sustainability are in doubt.
A poor system that may be in the early stages of
E <35 Nil
development or a non-existent system.

Source: Mercer, 2009

6
3. The need for occupational pensions
It is clear that Germany is not yet ready to meet the challenges of its aging population. The best
way to strengthen the system is to build a truly funded occupational pension system (second pillar)
with more retirement income coming from the employer and employees. Currently, around 80% of a
German’s retirement income comes from the state pension and only 6% from the employer. According
to ASID, (‘Alterssicherung in Deutschland’), only 4.2 million people above the age of 55 (private and
public sectors) were receiving a supplementary pension from their employer in 2007.

Closing the pension savings gaps will require more reforms and changes in consumer behaviour. The
question is: what role can companies play? And is it in their interests to make the effort in the first
place?

While further reforms are clearly the responsibility of the government, companies can play an
important role in building the second pillar by improving the financial education of their staff. Financial
education by the employer should be driven by three goals:
1. Actively communicate why employees should save more for retirement and adapt their personal
budgets if needed in order to do so.
2. Inform employees of the unique advantages of saving for an additional pension through the
employer.
3. Encourage employees to sign up for a supplementary pension through the employer and make it
easy to do so.

Communication should also be broad-based. As pointed out earlier, it’s not just low and average
earners who face pension gaps. The reduction in the pension level from the state will be highest for
high earners. In short, everyone is affected.

Defined Benefit plans in decline

Over the past 20 years, traditional final salary or Defined Benefit (DB) plans have been in steep
decline. These plans used to be offered as a voluntary benefit and were financed completely by the
employer. As the high costs of maintaining these plans have become evident, employer-financed DB
plans have either closed down completely, been drastically reduced in size or have been closed to new
entrants.

Salary conversion: new impetus for corporate pension provision

Against this background, the government needed to find another way to stimulate the provision of
occupational pensions. The answer came with the 2001 reforms, which introduced the legal right of
employees to require their employers to establish a retirement plan on their behalf.

Under this plan (known as ‘Entgeltumwandlung’), employees can convert up to a maximum of 4% of

their gross salary and wages (up to a maximum of €2,640 per year in 2010) into a pension contribution,
subject to the rules of the collective labour agreement. The 4% contribution is a form of deferred
income.

Importantly, the portion of gross salary that is converted into a pension premium is exempt from
social security contributions and tax. Initially this exemption was due to expire in 2008. In 2007,

7
 the legislator extended it indefinitely. This has given all stakeholders more planning security and is
expected to contribute to the further growth of occupational pensions.

The concept of tax relief for deferred income is not new in Germany. But, prior to 2001, it was offered
at the discretion of the employer. Today, employees have a legal right to this benefit.

The introduction of the 4% deferred compensation plan has changed corporate behaviour. Employer-
financed pension plans are increasingly being combined with salary conversion to make it more
attractive for employees to participate and build up a supplementary pension (through matching).
According to research commissioned by the German government, co-financed plans rose from 27%
of all plans in 2001 to 41% in 2004. By contrast, the creation of new pure employer-financed plans
has been close to nil since 2001.

Executive pensions on the rise

The shift to DC is also shifting more attention to the need to design attractive, innovative executive
pension packages. As already mentioned, the level of retirement income one can expect to
receive from the state is decreasing for everyone, but especially for those with salaries above the
social security ceiling of €66,000 (West Germany). Benefits from the state are also capped. The
4% of gross earnings that can be converted into a pension premium under the German salary
conversion plan is simply not attractive enough for many high-income executives. If companies
want to attract and retain management talent, they need to have something more.

Pension liabilities for directors and executives are putting a strain on many companies. According
to research by the Hans Böckler Foundation (which is closely related to the main labour union
umbrella group DGB), DAX companies’ total pension reserves for their former directors amounted
to around €2 billion in 2009, with an average increase to pension reserves of €7 million per
year.

The financial burden of building pension reserves for directors and other senior managers is
likely to be similar at non-DAX companies and multinational companies that wish to attract and
retain skilled specialists and executives.

8
4 Stimulating occupational pensions – a moral
­imperative?
Though employers are required to offer a supplementary pension plan at the request of an employee,
they are not required by law to contribute to it. Understandably, many companies are trying to cut
cost in the aftermath of the global financial crisis. But the 4% deferred compensation plan is the only
way for German workers to save for a supplementary pension from gross wages. This is particularly
beneficial for low to medium earners.

In addition, the exemption from tax and social security contributions from this plan automatically
cuts cost for the employer because, like the employee, the employer is also exempt from paying
contributions for social security. For an employee who takes full advantage of the 4% conversion, the
company’s savings per person are roughly €525 (20% of €2,640) per year.

By encouraging enrolment in a salary conversion plan, the employer also saves interest on tax
payments (‘Steuerstundungseffekt mit Zinseszinswirkung’) as well as taxes on capital and assets
(‘Gewerbekapitalsteuer’). Given the rapidly aging population in Germany, it makes sense for employers
to re-channel these savings as a matching contribution into a supplementary retirement plan for their
employees. This will not only boost employee satisfaction and motivation, but it’s also an effective
way to reduce turnover in the future.

Although employees are not required to sign up for salary conversion, there is a need for them to
do so in order to compensate for the effect of decreases in state benefits. Employers should assume
their responsibility and be proactive in helping their employees to build an additional pension.

A new deal between unions and employers?

Stimulating occupational pensions should not only be driven by employers but also by the labour
unions. An occupational pension is a crucial building block in the overall compensation package. Both
unions and employer organisations should recognize that increasing income for today’s workers will
become less important and higher contributions toward old-age provision more important. This will
benefit current and future generations of workers, and is therefore also more just.

When considering potential trade-offs between employer costs and employees’ wages in the future,
attention needs to be paid to maintaining the stability of workers’ total future income.

Following the gradual increase of the retirement age to 67 (with all new retirees starting at 67 from
2025) , it is also clear that not all employees will be able to or be required to work longer. However,
without sufficient pension savings, it may be difficult for some employees to leave employment. An
attractive and adequate employee benefits offering, including a supplementary pension, will help
motivate employees and increase employers’ flexibility.

9
 Becoming an employer of choice
Offering a supplementary pension can help employers attract and retain highly skilled talent. This
is particularly urgent now that Germany is emerging from the global economic crisis. Companies
already face a skills shortage, including engineers and scientists for research and development. The
competition for qualified staff will continue to increase sharply. The skills shortage is a long-term
trend that is being made worse by the shrinking working-age population. Employee benefits are an
essential tool in the ‘war for talent.’

Yet research indicates that employers often underestimate the importance of employee benefits.
According to Towers Watson’s latest report on global talent management, 86% of the employees
surveyed said a pension from the employer was an important consideration in deciding where they
worked. However, only 30% of employers surveyed agreed that a better pension would influence an
employee’s career choice. Clearly, there’s a mismatch in perception.

10
5 Communication is key
While the benefits of salary conversion for the employee and employer are undisputed, too few people
are enrolled in these plans at present.

According to the German Federation of Employers’ Associations (BDA), around 20 million workers
in 400 collective labour agreements are eligible for the 4% salary conversion plan. Since the
introduction of these plans in 2001, the number of people enrolled in occupational pension plans
has clearly increased, but participation is not as high as it could be. One major reason for this is that
employers are not providing sufficient information to their employees, and so many employees are
unaware of their right to participate in such a plan.

A survey conducted this year among 1,000 people by the Institute for Management and Economic
Research (IMFW) in cooperation with Hannoversche Leben found that:
• around half the respondents had not received any information from their employer about the
possibility of setting up an occupational pension plan;
• of this group, 70% were not even aware they had a legal right to it;
• this lack of awareness was particularly pronounced among those earning €1,000-2,000 net per
month.

This attitude is validated in research that is regularly commissioned by the German ministry for
labour and social affairs. The researchers ask companies for the reasons they have not introduced an
occupational pension. The dominant reason named is always lack of interest by employees.

Figure 4: Reasons for not introducing an occupational pension in private sector

Lack of interest
by employees 65%

Costs for company

to high 43%

Topic too complex 18%

Staff turnover too high 8%

Does not know
employees have right 6%
to salary conversion
Other reasons 11%

0 20% 40% 60% 80% 100%

Source: TNS Infratest, DIA 2010

11
 Educating and encouraging employees
As long as companies don’t communicate the benefits of supplementary pensions to employees and
encourage them to use them, employees will remain uninformed and disinterested. Take-up could be
rapidly increased if employees were made aware of the unique advantages of an occupational plan
over other savings forms (including state-subsidised private pensions), namely:
• employees have a legal right to salary conversion
• employers are able to make matching contributions, enabling savings to grow twice as fast
• occupational pensions are subject to legal compensation for inflation
• they typically offer higher returns than private savings (even those products that enjoy tax relief,
such as the Riester Rente)
• the salary conversion plan is the only way in Germany to save for a supplementary pension from
gross earnings.

Companies should take the initiative to communicate the unique selling points of salary conversion and
turn lack of interest into enthusiasm and action. Companies and labour unions have a responsibility to
educate and inform workers about pension gaps and to encourage enrolment so that employees can
save sufficient resources to be able to enjoy a comfortable retirement.

It may be hoped that future government reforms make it obligatory for employers to inform their
employees about the possibilities of the salary conversion plan. In addition, Germany may look to
follow the example of several other countries, including Australia and the UK, who have introduced or
are introducing auto-enrolment in order to increase the use of occupational pension plans.

12
 6 The rise of external financing vehicles
In setting up new retirement plans based on salary conversion, German companies have a number of
choices.

German occupational pensions (the second pillar) can be divided into two sub-pillars: direct pension
promises and indirect pension promises. In total, there are five ways to set up corporate pension
provision. Each method has very different functions and offers its own distinct advantages and
disadvantages. Around 85% of small to medium-sized (Mittelstand) companies use a combination of
vehicles, according to research by Allianz.

For new plans based on salary conversion, direct insurance is the most popular financing method for
the Mittelstand, followed by the captive pension society (Pensionskasse).

Figure 5: Use of pension financing vehicles by Mittelstand

For salary conversion schemes For employer-financed plans

Direct insurance 82% 33%

Pension captives 54% 24%

Direct 17% 73%

pension promise

Pension fund 17% 7%

Support fund 13% 26%

0 20% 40% 60% 80% 100% 0 20% 40% 60% 80% 100%

Source: Allianz, 2010

The rise of pension funds and CTAs

Of the five pension vehicles, the pension fund shows the most potential and the highest growth. The
pension fund was created 10 years ago as an internationally recognised alternative to the insurance-
based captive pension society (Pensionskasse). Approximately €14bn of pension assets are currently
held in pension funds. The reason for their rapid growth is twofold. They pay reduced levies for the
German Pension Insurance Association (PSV) and offer more freedom in investment choice.

However, the pension fund is subject to a cap on the transfer of future accruals at a rate of €2,500
per year. As a result, it is mainly used as a vehicle for past accruals. In order to be able to manage the
liabilities of future accruals, companies are increasingly setting up pension funds in combination with
Contractual Trust Arrangements (CTA), which allow the accrual of future liabilities.

13
 Five ways to finance occupational pensions in Germany
 irect pension promise: The employer is directly responsible for meeting the pension
1. D
promise. The employer accrues for pension liabilities on the balance sheet and pays pensions
from cash flow. Most companies insure their direct pension promises through an insurance
company.

Indirect pension promises:

 ension societies (Pensionskassen): The second largest financing method. Pension
2. P
societies are outsourced and legally independent entities. These can be used either for a
single company or an entire industry sector. The pension society takes out an insurance
contract for the employee and builds up capital from which the pension is paid. Pension
societies are regulated by the Bafin, the German financial regulator. As a result, the employer
is not required to pay into the Pension Insurance Association (PSV). Plan participants have a
claim against the pension society. Until 2000, the role of the pension society was restricted
to company and industry pension societies. Since 2002, various competing pension societies
have been established, mainly by insurance companies.

3.  Support fund: Like Pensionskassen, these are outsourced, externally-funded pension plans.
Unlike Pensionskassen, employers must pay into the PSV as the plan participants have
a pension claim against the corporation instead of the fund. A company can pay in almost
unlimited amounts of contributions tax-free. This is particularly attractive for higher incomes.
For example, if an executive earns €500,000 the company can pay €200,000 into the support
fund on his or her behalf. The only requirement is that the previous year’s contribution is the
minimum that needs to be paid in the following years. Like a pension society, a support fund
can also be set up for a larger company, and smaller companies can become a member of a
larger support fund.

4.  Direct/primary insurance: Companies take out an insurance contract directly with an insurer
on behalf of the employee. The administrative burden is low and no PSV contributions are
paid.

 ension funds: Created in 2001 as the fifth financing method in order to create an
5.  P
internationally recognized alternative to the other insurance-based financing vehicles. Pension
funds account for just 3.2% of total pension assets. Transferring a company’s existing direct
and support fund commitments can bring some tax relief. The transfer of future accruals into
a pension fund is limited to €2,640 per person per year. Voluntary transfers from pension
captives into the pension fund are not allowed. There are around €17 billion in pension funds,
€15 billion of which are held by 8 company pension funds with the remainder offered by
insurers to clients. Regulations for pension funds are regarded as rather rigid.

As enrolment in salary conversion plans increases and companies seek to design attractive new
pensions plans for their executives, external financing vehicles such as pension funds, direct insurance,
support funds and pension captive societies will become more important.

Total pension assets in the German second pillar amounted to EUR 453.8 billion in 20081. This, too,
is relatively small compared to other European countries.
1 According to the German Working Group for Occupational Pensions (aba)

14
 Figure 6: Size of 2nd pillar in selected European countries in EUR billion (2008)

1202
1200
Direct pension promises (book reserves) 12.3
1000 Pension fund societies
Direct insurance
Support funds
800
Pension funds
578
600
454 245 (54%)

400
4.6 107 (23.6%)
209 49,8 (11%)
200
122
48 37 (8.2%)
14,4 (3.2%)
0
Belgium France Denmark Germany NL UK

Source: European Federation for Retirement Provision (EFRP), 2010 Annual Report, aba

Book reserved plans – a model in decline

In the light of the economic crisis and increasing longevity, companies need to reconsider the risks
of their current plans, in particular, their direct pension promises. The direct pension promise is still
the most widespread financing vehicle in Germany, accounting for over half of all pension assets in
Germany. Yet the economic crisis and the introduction of new German accounting standards have
exposed new risks to companies, making book reserving less attractive.

In addition, the increased contribution rates for the Pension Insurance Association (PSV) are also
prompting many companies to turn to external financing vehicles. All companies that make a direct
pension promise and build pension reserves must be a member of PSV, which finances itself from
contributions and pays out pensions in case of insolvency. But in the wake of the financial crisis, the
PSV contribution rate rose to a record 14.2% of pension liabilities in 2009 compared to 1.8% in 2008
and 3% in 2007. As a result, IBM Germany has recently announced its plan to set up a pension fund to
avoid the high pension solvency levies to the PSV and transfer funds and members from its pension
support fund to the pension fund.

IBM Germany noted that while the PSV was an important ‘solidarity principle’ for the German economy,
it had led, at a time of increasing insolvencies, to ‘well managed, healthy companies having to come
to the aid of those that have run into difficulties and have not – like IBM – sufficiently provided for
pension liabilities they have taken on’. The high PSV rates have also put a dent in company earnings.

Germany is unique for its high reliance on the book reserve system. German accounting rules require
that companies that make a direct pension promise build pension reserves on the balance sheet. The
employer pays the pension directly from cash flow when the pension liability falls due. Book reserves
can be established for both DB and DC plans.

Direct pension promises are often interpreted outside Germany as being unfunded. In fact, they are
internally funded and integrated with business assets. Direct pension promises must be recognized

15
 at their full value as a liability on the balance sheet and, as with any balance sheet, the assets and
liabilities must be balanced. The difference is that the offset does not guarantee automatic accounting
liquidity on an accruals basis.

Clearly, the book reserve system is very different from the way pensions are financed in other
countries. As Raimund Rhiel of Mercer has commented,

‘The high incidence of unfunded pension liabilities among German companies reflects a major difference
between the balance sheets of typical German companies and their Anglo-Saxon counterparts. The
German perspective is that non-German companies hide their pension liabilities in external pension
funds. The foreign perspective of German companies is that they maintain unfunded or unsecured
pension plans.’

Despite the existence of other methods for external pension funding, many companies prefer the
internal book reserve system because it has always been simple and tax-effective. Building pension
reserves has also been popular because it served as a cheap form of debt and an effective source of
liquidity for the company.

Time to derisk?
While book reserving has offered advantages in the past, new German accounting rules (‘BilMoG’)
which went into effect in 2010 are diluting those advantages. BilMoG aims to align German accounting
standards more closely with IFRS, and particularly with IAS 19 (which concerns the accounting of
retirement benefits and which many large international companies already apply) and to increase the
acceptance of the German commercial balance sheet abroad.

BilMoG – making pension liabilities more transparent

BilMoG has major consequences for the valuation of pension liabilities. Liability gaps will become
more transparent under BilMoG. In the past, the German commercial balance (HGB) was thought
to understate the value of pension provisions because companies did not have to take pension and
salary increases into account. This led to the perception that German companies provided incomplete
and misleading information.

Companies must now value their pension liabilities using more realistic economic assumptions. For
example, in the past, employers could accrue for pension liabilities using a 6% discount rate and could
deduct unfunded accruals for pension cost from taxable income. The interest rate under BilMoG for
discounting pension provisions will be lower (currently around 5.2%), which will increase liabilities. In
some cases, the increase could be significant. Companies now also have to take salary and pension
increases into account.

On average, book reserves account for 10% of total assets for a typical Mittelstand company. The
defined benefit obligation (DBO) under BilMoG could be twice as high as on the German commercial
balance sheet (HGB).

The adjusted and increased accruals could reduce net profit, impacting the basis for dividend
payments. In the case of a significant increase in pension liabilities, companies will be allowed to
amortize the additional accruals to pension reserves over 15 years. This could improve the view of the
balance sheet and improve equity ratios.

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 Key features of BilMoG
• Only affects commercial balance sheet.
• Discount rate for pension liabilities will be lower than past 6% rate.
• Increases in salary and pension have to be considered when calculating liability.
• Two actuarial reports will be necessary in the future.
• Netting is allowed for the first time. In order to fulfil the conditions of netting, companies must
have segregated plan assets and the plan assets must be protected from creditors.
• 15-year grace period to adjust pension liabilities.

Derisking pensions
Companies that need to report according to IFRS, IAS or US GAAP are practically forced to switch to
externally financed methods because of BilMoG. As a result, companies are also increasingly looking
to outsource their direct pension promises. Over two-thirds of DAX companies have already done so,
although the Mittelstand companies have so far been less enthusiastic.

A clear trend within the outsourcing of direct pension promises is using a combination of pension funds
(Pensionfonds) for holding past-service commitments and group support funds for future service.
These two types of financing methods are becoming increasingly significant. This is particularly true
for companies that apply international accounting standards (such as GAAP or IAS 19), as direct
pension promises that are not matched by segregated plan assets can reduce a company’s credit
rating. This in turn can threaten the company’s ability to finance or refinance its activities.

Although outsourced, indirect pension financing vehicles are becoming increasingly significant for
new pension plans, companies with direct pension promises are building up their financial resources
in three ways:

• pledging assets directly to cover the liabilities to specific groups of employees

• earmarking specific groups to be covered in reinsurance policies, or
• creating a form of group pledge within a Group CTA (Contractual Trust Arrangement).

BilMog allows netting for the first time in order to improve the view of the balance sheet and prevent
the erosion of funding ratios. But in order to fulfil the conditions of netting, companies must have
separately allocated and segregated pension plan assets in place, and the plan assets must be
protected from creditors.

Building segregated plan assets for direct pension promises also makes sense in the wake of the
financial crisis and recent market volatility. Many multinational companies increasingly realize how
important it is to have sufficient liquidity. Indeed, one of the biggest disadvantages of the book
reserve system is not having sufficient liquidity at the moment that the company needs to pay out
pensioners. In the past, external pension financing was mainly motivated by tax considerations.
However, increasing longevity and low interest rates have increased the need for capital. Due to the
economic crisis, finding ways to improve pension governance and reduce the volatility of business
assets and liabilities has moved to centre stage.

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 7 Building sustainable pensions – eight guidelines
Although it is clear that companies need to take another look at how they provide pensions, the
solutions available are varied, and which solutions individual companies choose depends on their
specific situation and needs. There is no simple ‘one size fits all’ solution. However, it is possible to
provide some guidelines on how companies should approach their pensions in order to make them fit
for the future.

Figure 7: Designing a new plan?

For all employees For executives

• Matching through support fund • Reinsure DB elements one to one:

(employer financed) Lump-sum payments to survivors,
Disability, AD&D cover, Etc.
• Salary conversion through direct
insurance • Keep (or move) old-age pension
(employee financed) to DC basis

Source: AEGON Global Pensions

Guideline 1: Improve communication to your employees. Is everyone in your company enrolled in

salary conversion? Following the introduction of the salary conversion plan in 2001,
there was a need for information and education, and the works councils played a
significant role. This led to some innovative concepts. Now that the tax exemption for
this plan has been expanded indefinitely, salary conversion should get an extra boost.

Guideline 2: Don’t just think of pensions: what other employee benefits do you offer?

Guideline 3: Examine the need for executive pensions in your company. Carry out a thorough analysis
of current benefits you are offering.

Guideline 4: Analyse your current DB and DC plans for risks. There are many solutions available to
derisk depending on the nature of the company and many other factors. Some solutions
are easier for small to medium sized companies. Setting up a CTA has become more
popular, but it’s not the best solution for all types of companies.

Guideline 5: Check your liquidity situation. Does the liquidity of your assets match liquidity of
liabilities? Is it time to set up segregated plan assets?

Guideline 6: Examine your talent management needs. How many expats do you have? What sort of
retirement plan is in place for them? Do they need a better pension solution to reflect
their international mobility? Do they need an international retirement plan?

Guideline 7: Is it time to pool your company’s cross-border pension assets as a way to derisk and
improve pension governance?

Guideline 8: Analyse impact of BilMoG on your company’s pension commitments, key ratios, funding
eeds, etc. Is there a need to derisk?

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8 Time to act
Germany is not unique in facing serious challenges with its pensions, but the German pension system
itself is unique. As such, Germany requires a different set of solutions from other countries. However,
this does not mean that there are not lessons to be learned from looking across borders. As the role
of the state in providing pensions diminishes, companies can – and should – step into the gap. By
looking to countries where similar processes have taken place, it is possible for companies to learn
from experiences elsewhere.

Both employers and employees need to realise that change is inevitable, if people wish to be able to
retire on anything like the income they have become accustomed to. For individuals, the personal
risk of not having an adequate pension is clear (although they may not yet be aware of the enormous
potential shortfall that they face), but the reputational and operational risk to companies is also
significant. However, the present situation also presents companies with a clear opportunity to take
responsibility for helping and stimulating their employees to save for their retirement.

The German pension system is clearly at a moment of change. Major internationally operating
companies are moving away from the traditional book reserve system and looking to provide pensions
in other ways. Small and medium-sized businesses may not be so quick to follow, but they too should
be looking again to see what they can do to assist their employees and help build a sustainable
pension environment in Germany.

Figure 8: Time to derisk? A game plan for non-DAX companies

Book
reserved plans

Step 1 Step 2

REINSURE OUTSOURCE

Does company have high liquidity? A. Past service + previous reinsurance

Go to Step 2 > > Pension fund
B. Future service > Group support fund

Source: AEGON Global Pensions

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 Acknowledgements
I would like to thank the following people for providing their knowledge and insight.
Rüdiger Blaich

Diane Baumann
Corporate communications consultant
Harry Brand 
Regional director, HDI Gerling Leben Vertriebsservice
Jörg Liely
HDI Gerling Leben Vertriebsservice
Thurstan Robinson
Communications manager, AEGON Global Pensions
Martijn Tans
Director marketing, AEGON Global Pensions

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References and notes
Allianz Global Economic Research, Economic Trend Report, ‘Die deutsche Rentenversicherung nach
der Riester-Reform‘, Ausgabe 3, July 2003
Allianz Global Investors, ‘Mittelstands-Studie zur betrieblischen Altersversorgung, Ausfinanzierung
von Pensionsverpflichtungen als Herausforderung der Zukunft’, July 2010
Arbeitsgemeinschaft für betriebliche Altersversorgung, E.V (aba), aba-online.de
Aviva Europe, aviva.com/ Europe-pensions-gap/executive-summary
BDA, kompakt, ‘Betribliche Altersvorsorge’, January 2010
BDA, ‘Entgeltumwandlung für betriebliche Altersvorsorge: Beitragsfreiheit erhalten, Doppelbelastung
verhindern!’, June 2007
BDA, ‘Betriebliche Altervorsorge stärken, Reformvorschläge zur betrieblichen Altersvorsorge’, May
2009
‘Bevölkerung Deutschlands bis 2050, 11. koordinierte Bevölkerungsvorausberechnung‘, Statistisches
Bundesamt, November 2006.
Börsch-Supan, A., Reil-Held, A. and Wilke, C. ‘How an Unfunded Pension System looks like Defined
Benefits but works like Defined Contributions: The German Pension Reform’, May 2007, University of
Mannheim
Börsch-Supan, A., Reil-Held, A., and Wilke, C., ‘Zur Sozialversicherungsfreiheit der Entgeltumwandlung’,
University of Mannheim, May 2007
Bräuninger, D., Deutsche Bank Research, ‘Betriebliche Altersversorgung: Raum für weitere Expansion’,
30 June 2010
Cresswell, N., Horneff, W., and Wildner, S., Towers Watson, ‘Germany: risk and occupational
pensions.’
de Meza, D., Irlenbusch, B. and Reyniers, D., ‘Financial Capability: A Behavioural Economics Perspective’,
prepared for the FSA, July 2008
Ernst & Young and BDI (Federation of German Industries), ‘German Accounting Law Modernization
Act (BilMoG)’
European Federation for Retirement Provision (EFRP), 2010 Annual Report
GDV, ’Nach der Reform, Das bringt die neue Rente,’ 2002
German pension liabilities set to surge as BilMoG takes effect, 29 June 2010, IPE.com
Hainz, G., and Thurnes, G., ’Germany: BilMoG reforms ring the changes’, IPE.com, April 2010
HDI Gerling, „Trendstudie: bAV im Mittelstand in Zeiten der Finanzkrise’,
Kinzer, M., ‘Reshuffling the cards in Germany, an outline of recent reforms in German life insurance
market’, Towers Watson.
Kinzer, M., Towers Watson, ’Reshuffling the cards in Germany’, www.watstonwyatt.com/europe
Melbourne Centre for Financial Studies and Mercer, ‘Melbourne Mercer Global Pension Index’, October
2009.

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 Ministry of Finance, ‘Das Alterseinkünftegesetz: Gerecht für jung und alt’, June 2005
OECD, Pensions at a Glance 2009, Germany
Ottowa, B., IPE.com, ‘German companies keeping workers in the dark on pension schemes’, September
2010
Prast, H., and Thomas, C., ‘Behaviour and Biases: Implications for the government as choice architect’,
Introduction, 2009.
PriceWaterhouseCoopers, ‘10 Minuten BilMoG: Pensionen und CTA’, November 2008
Raimund Rhiel, ‘What’s new in Germany: Funding via CTA and Pensionsfonds’, June 22, 2007,
Mercer.
Recktenwald, S., ‘Betriebliche Altersversorgung: Ohne geht es nicht! Soziale Verantwortung für
Unternehmen/Win-win Situation,’ Towers Watson Germany, Benefits! Magazine
Ergänzender Bericht der Bundesregierung zum Rentenversicherungsbericht 2008 gemäß § 154
Abs. 2 SGB VI (Alterssicherungsbericht 2008), Ministry of Labour and Social Affairs‚ Alterssicherung
in Deutschland 2007 (ASID ’07), Zusammenfassung wichtiger Untersuchungs-ergebnisse, TNS
Infratest
Williams, J., IPE.com, ‘DAX companies amass EUR 2bn pension reserves for former directors’, July 9,
2010
Williams, J., IPE.com, ‘German pension liabilities set to surge as BilMoG takes effect’, June 29, 2010

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 AEGON Global Pensions

AEGON Global Pensions is part of AEGON, an international life insurance, pension and investment
management company that operates in 20 countries and serves more than 40 million
customers.

The specialists of AEGON Global Pensions and our partners in Germany can help your company
design attractive new employer pension plans and de-risk existing plans. We act as a single point
of contact for multinational companies, providing access to a wide range of pension solutions and
expertise around the world, including the International Retirement Plan for expatriates, derisking
of defined benefit plans, cross-border asset pooling (available in Germany as from 2011), Total
Retirement Outsourcing (TRO) in the US, and single- and multi-pension solutions.

We can also help multinationals with headquarters in other countries that wish to include Germany
as part of their international pension strategy.

HDI-Gerling, an AEGON Global Pensions partner in Germany, offers a wide range of external
funding methods (reinsurance plans, full reinsurance, partial reinsurance) and outsourcing
solutions (pension fund for accrued rights, support fund for entitlements to be accrued, support
fund for beneficiaries). It also provides advice on the impact of BilMog as well as labour and tax
law on pension liabilities. It can help set up a CTA model.

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 Contact details

AEGON Global Pensions

Rüdiger Blaich
Erich-Schmid-Str. 13
71638 Ludwigsburg
Deutschland

Tel.: +49 7141 648 3980

www.aegonglobalpensions.com
ruediger.blaich@aegon.com

Disclaimer
This research paper contains general information only and does not constitute a solicitation or offer.
No rights can be derived from this research paper. AEGON Global Pensions, its partners and any of
their affiliates or employees do not guarantee, warrant or represent the accuracy or completeness of
the information contained in this research paper.

AEGON, October 2010

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