Human Resources: Reform of Pension System Impacts Employers in Germany

Germany´s reform of its pension system will impact all employers from January 2002 when sweeping change to labor and tax codes, intended to stimulate long-term savings in the private sector, and well-publicized cutbacks in social benefits take effect. Social security benefits are expected to erode for the foreseeable future as the social system reconciles rising demand with long-term budgetary constraints. To counter high labor costs and rising unemployment in one of the world´s most rapidly graying populations, the government has capped social contributions through 2030.

Aimed particularly at young and mobile workers, the new pension system facilitates true defined contribution and salary sacrifice plans and makes defined benefit pension promises more portable with reduced vesting periods and a lower minimum age requirement. The new system also creates a government subsidy to offset the decrease in social benefits. To obtain the government subsidies employees must contribute to a personal savings plan, either private or employer sponsored.

The reform marks a significant departure for a country with a long tradition of social obligation and limited opportunities, especially for individuals, to save on a tax-favored basis. Legislation to refine the new system is anticipated for the next few years. The responsibility is placed squarely on employers to re-evaluate their retirement savings strategy and prepare for a sea change in the competitive environment, awakened employee interest in corporate sponsored benefits and on-going legislative compliance.

The measure most immediately effecting employers is the legal obligation to provide employees with a "certified" deferred compensation plan on demand, unless the employer is already offering a salary sacrifice plan implemented before 01.01.2002. Employers can expect employees, work councils and collective bargaining units to more closely scrutinize occupational arrangements and demand compulsory deferred compensation plans - industry wide as well as employer sponsored - to gain access to state subsidies.

Some experts believe that most employees will be better off in non-certified plans due to the terms of certification and the modest initial government subsidies. Among the requirements for certification are that contributions must be paid from net income, after tax and social contributions, and employees must be able to utilize a new investment vehicle, Pensionsfonds.

Pensionsfonds are legally independent institutions granting the employee a direct legal claim to benefits, thereby ensuring portability without impacting employers´ balance sheets. The maximum annual contribution is 4% of the social security contribution limit, approximately €2,150 in 2002. Final regulations are due but they appear to offer a wider choice of investment options than insurance companies. Retirement benefits are payable only as a life annuity and disability and survivors benefits are limited.

Cash and tax subsidies for certified plans are being phased in through 2008. In 2002 the maximum contribution to attract the government subsidy is €525 on which the government will provide a base amount of €38 plus €46 for each child. In 2008 the maximum contribution is expected to rise to €2,100, the basic transfer to €154 and the amount per child to €185.

The "best" approach for salary deferral plans, whether certified or a traditional employer sponsored approach, is a complex task varying by individual income and family size. It will be left to employers to examine and compare the two in order to respond constructively to workforce demands.

There are also implications for employers sponsoring hybrid defined contribution and defined benefit retirement plans. Due to the tax system, it has not been possible until now to utilize true defined contribution plans where the rate of contribution is based purely on company or competitive practice. Instead, companies have been forced to set contribution rates based on a "hidden" defined benefit formula. To comply with the new system hybrid defined contribution plans can now be converted to true defined contribution plans. Defined benefit plans will need to adjust to a five rather than 10-year vesting period and a minimum age requirement of 30 from 35 years.

Despite the increased portability and transparency of revised retirement plans, they are likely to come under intense scrutiny and harsh criticism by employees if projected benefits together with reduced social benefits appear insufficient to ensure "reasonable" levels of income. (Summary of 2002 cutbacks in social benefits follows).

Survivor and disability benefits, both of which are typically provided in defined benefit and defined contribution plans, will also be scrutinized. Under a typical German defined benefit plan survivor and disability benefits are proportional to the employee´s projected or accrued retirement benefit and payable as pensions. Defined contribution plans generally pay out accrued account balances and some also provide additional lump sum death and disability pensions. Those plans that provide only for the distribution of account balances are easy targets; particularly as account balances tend to be low in the early years of participation.

Currently 19.1% on salary below the social security salary ceiling, social contributions must remain below 20% until 2020 and 22% until 2030. Next year´s benefit cuts are the first of many:

Retirement pension after a full (45 year) career reduces from 70% of average covered career earnings to approximately 64% until 2030;

Survivor pensions now means-tested and decrease from 60% to approximately 55% of decedent´s pension; and

Disability pensions are down about 10% and subject to a more rigorous test of total disability. Claimants not meeting test receive 50% of pension.

Despite its complexity and myriad effects on employers the government has left no doubt in the new legislation that it endorses employer sponsored retirement savings arrangements over individual savings plans for their low risk and cost effectiveness. The re-writing of the social contract challenges employers to look objectively at the current value of their pension and salary sacrifice plans, keep close track and pace with changing competitive practice and communicate clearly and responsively with employees and the market.