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The German Pension Crisis: It Is No October Fest

Over a decade ago, the collapse of the Berlin wall ushered in a new era of cultural change, unity and national pride in Germany. The overwhelming political and humanitarian impact of this transformation stands firmly as one of the World's most defining moments. However, with this wave of change came a series of economic obstacles that remain a very prevalent legacy of Reunification. As the Wall fell and economic unity began, 16 million inhabitants of East Germany flooded into the West German social security system. A system that was unable to fully meet the responsibilities and burdens that come with historic change. Today, one of the most pressing concerns is the $10 billion public pension fund deficit. With the elderly population rapidly increasing and birth rates plunging, all parties involved recognize that the publicly supported Pay-As-You-Go system is no longer a sustainable option. The problem is further exasperated by a slumping German economy and one of the highest unemployment rates in the industrial world. As Germany stands on the threshold of financial crisis, it once again must confront a difficult but necessary period of change.

The cornerstone for this transformation depends upon convincing the German public to switch from a purely collective Pay-As-You-Go system to a capital funded system with individual retirement accounts. Yet if the economy is to rebound, the government believes employer contributions must remain level. As such, the burden of the $10bn deficit shifts to the workers. They will now be expected to finance the majority of their pensions and manage the risks associated with that task. This is a lofty goal in an environment where psychological barriers need to be torn down, to replace a failing paternalistic system.

The German government is working hard to breakdown this obstacle while simultaneously taking realistic steps to repair its broken system. In 2001, it adopted a major pension reform program, known as the "Riester Reforms." The new program begins with a government commitment to keep the employer contribution rate to pension benefits below 20 percent of gross salary until 2020. In the long-term, the goal is to stay below 22 percent until 2030. In order to balance these benefit cuts, the government has introduced state subsidies, tax incentives and employee rights that promote voluntary retirement savings and investment. Employees now have the ability to demand that their employer provide access to a pension plan that takes contributions from his/her salary. New vesting rules will facilitate the introduction of defined contribution plans, while also making pensions more portable for young, mobile employees. All of these changes set the stage for a system that provides the individual with greater freedom to manage their own future and the government with greater flexibility in managing the pension deficit.

It is in this atmosphere that Stable Value products can start carving out a role in this new era of pension reform. One component of the Riester Plan that lends itself to Stable Value products is a new type of funding vehicle called Pensionsfonds. It is a separate legal entity that provides pension benefits for employees on behalf of their employers. Pensionsfonds are the first tax-qualified funding vehicle not subject to the conservative investment restrictions that apply to German insurance companies. Stable Value products will provide individuals with an opportunity to take advantage of the reduced restrictions on higher yielding instruments, while at the same time lowering portfolio exposure to market volatility. The wrap achieves this by amortizing the gains (losses) over the duration of the fund. It serves as a cost efficient hedging mechanism that provides protection against a decline in asset value. Although to date, Stable Value products have not been approved, if properly marketed, they have the potential to provide a level of security for investors that will be critical in getting individuals comfortable with shouldering this new risk.

Furthermore, although investors will be taking on more accountability for their post retirement future than ever before, it is clear that the German government is not prepared to hand off 100 percent of the responsibility to the public. German companies will also assume risk. All pension products instituted under the Riester Reforms will have mandatory safeguards. Pensionfonds will have to guarantee a minimum benefit equal to the initial investment by the employee. Although employees normally have a direct claim against the Pensionfonds, in the case of fund insolvency the sponsor company would provide the minimum guarantee. As a result, the government mandates that each company take out an insurance policy with the PSVaG¹ to protect against credit risk. Yet despite the insurance, companies still face the problem of managing market risk. Stable Value products can provide the solution. In what amounts to the purchase of a put option, to protect against losses, and the sale of a call option to the wrap provider, the sponsor company can create a maximum loss floor. The wrap sponsor assumes all risk of the market falling below the initial investment value and the company is shielded from pension liabilities in the case of rapid market deterioration.

Despite the added advantages that a product such as Stable Value can present it is still unclear how receptive the public will be to the Riester Reforms. The shape this new era of pension reform will take has yet to be fully molded. Many critics believe that the Riester solutions are too complex, expensive and poorly constructed. For example, the amount of money that can be contributed to Pensionfonds before triggering an income-tax liability for the employee is viewed as too low to adequately fund benefits. Others believe that there are far more tax efficient funding arrangements for employers. As a result, pension policy and products that are relevant today may not be relevant tomorrow. This continued state of flux presents a risk to any outsider attempting to enter the German pension market. Nevertheless, while it is still too early to determine how rapidly the public will embrace this wave of reform, it is clear that the barriers to change are once again falling in Germany and it presents a potential opportunity for Stable Value products.

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