Pension reform

A Vain Hope

  • Why it matters

    Why it matters

    Germany has seen many pension reforms since the end of World War II. With the population aging, the new government will have to address several issues to keep the program running smoothly.

  • Facts

    Facts

    • In 1957, the German government first introduced a pay-as-you-go “dynamic pension” system. Since then a patchwork of measures and new rules have been introduced.
    • Germany’s aging population and lower birth rates are putting pressure on the pension system. This is one argument for widening the pool of German workers paying into the pension fund.
    • Compared to other countries, rates of old-age poverty remain relatively low in Germany, affecting around 3 percent of those above retirement age.
  • Audio

    Audio

  • Pdf
Elderly woman pushes walking frame through shopping centre in Berlin
Moving on: Germany's pension system is made up of a patchwork of rules and needs reform. Source: Reuters

In most countries, a pension is seen as maintaining a person’s standard of living if it pays out about 70 percent of their average income from his or her last few working years. Only this measure hasn’t been reached in the history of Germany’s statutory pension system.

That’s because individual pensions have been calculated in accordance with the principle of “contribution equivalence” ever since 1957. Under this principle, the first few years working, where pay is usually relatively low, have the same impact on the pension paid out as the last few years before a person retires, during which the highest salaries are usually earned.

Contrary to popular belief, the calculations are then based on the “standard pension” of a fictitious retiree who paid contributions from his or her average wage for 45 years. The pension level is the ratio between this standard pension and the person’s own average wage.

Raising the retirement age is not the silver bullet many see it as.

The system was tweaked just in the last few years. The so-called mothers’ pension was introduced in July 2014 and the retirement age was reduced to 63 for some workers, were questionable expansions catering to a specific and limited clientele.

By contrast the remaining plans for this legislative period, assuming they are still passed, should be welcomed: They include establishing an equal playing field between eastern and western Germany under pension law, further increases in pensions for those with reduced earning capacity and advancing the expansion of fully-funded private and company pension schemes.

If these efforts come to fruition, no matter who is elected in September, the next federal government will have to deal with the following urgent issues around pension policy: How much federal tax revenue should be used to finance pensions, how to prevent an increase in old-age poverty and the growing the number of people who are included in the pension scheme.

One might think that a quick decision on further increasing the retirement age is key, since it is being pushed for by the Bundesbank, the German Council of Economic Experts and leading economists like Hans-Werner Sinn and Axel Börsch-Supan.

Yet the question of raising the standard retirement age to 69 or even 70 is not an acute issue. It will only be relevant in the legislative period after the next one, since it relates to the period after 2030. Germany is already transitioning from the currenty 65 to retiring at 67, which will only be complete at the end of 2031.

In fact, the demand by experts for raising the age now is nothing but a value judgment: It’s based on a belief that the relationship between the number of years worked by a standard retiree and the length of time they might draw a pension – which changes according to life expectancy – should remain constant, so that the costs of longer benefit periods can be proportionately distributed among future retirees. This judgement can be shared, but it doesn’t have to be.

Raising the retirement age is not the silver bullet many see it as, but really just one of several alternatives to redistribute the costs that come from – even after structural reforms – an aging population. Other options include raising the rate of contributions, which would affect the working population, or reducing the pensions paid, which would affect both current and future retirees, or a higher contribution through taxes, which would create a burden on all taxpayers.

Economists will argue that productivity increases when the payment of pensions is delayed. Whether this is a sufficient argument to ignore the widespread desire for a lower retirement age is something no economist can determine. Only a majority in the German parliament can do that.

03 p53 Pensions in Germany-01 contributions pay-out

The first item on the next federal government’s to-do list on pensions should be reorganizing how much of a contribution they themselves make to pension payments. Since 1957, federal taxes have been used to supplement pensions. Allegedly the most significant factors in determining the level of any individual pension are contribution equivalence and how much a worker has paid into the pension pot during his working life. This means that the additional federal funding is seen as extra payment that is supposed to benefit society in general; it provides unquantifiable social benefits. But truth be told, nobody knows exactly what those unquantifiable social benefits actually are.

The pension insurance fund does occasionally publish lists of these benefits, but they change over time. By sheer coincidence, the expenditure volume for these benefits is always almost exactly equal to the actual tax subsidies. Recently the argument for these social benefits has become a complete farce, with Labor Minister Andrea Nahles pushing for eco-taxes and so-called “demographic subsidies.”

In the interests of transparency, we should forget about these unquantifiable social benefits. A clean solution would be to transition to a federal contribution in the form of a fixed percentage of total expenditure, which would also give the federal government more of a say. The proportion of tax sits at about 26 percent of pension expenditure.

A fixed and reliable method of financing like this would strengthen the financial stability of the system. This would come at the cost of weakening the principle of contribution equivalence. In return though, it would help to prevent old-age poverty at a time when ongoing funding is increasingly complicated by demographics and technological changes.

 

The notion that old-age poverty is spreading, a notion being peddled by welfare organizations and the Left Party, is not at all accurate.

The risk of becoming dependent on government welfare in one’s old age – that is, basic subsistence income for the elderly – has been increasing for years. Nevertheless, by international standards and in comparison with the working age population, that risk is still very low. According to current figures, more than 522,000 people receive basic subsistence income for the elderly.

The number has stagnated recently and corresponds to about 3 percent of those above retirement age. It is difficult to get this benefit, as it requires a strict means test. But the notion that old-age poverty is spreading, a notion being peddled by welfare organizations and the Left Party, is not at all accurate.

According to a study by Germany’s Research Network on Pensions, a quarter of these welfare recipients receive no pension at all while another 40 percent receive a pension of less than €400 a month. The most important reasons for old-age poverty are disability and missing contributions to the pension fund, which means that most of those living in old-age poverty today would still be dependent on government welfare even if pensions were paid out at 65 percent of their former income. This is why the Left Party’s claim that the statutory pension is “structurally poverty-proof” if the pension level were raised to 53 percent, is wrong.

To confront the widespread fear of old-age poverty and to increase the acceptance of pensions funded by mandatory contributions, it would be smart to relax the equivalence principle and make pensions more poverty-proof.

The equivalence principle means that insured people who pay contributions on high income for a long time receive a large pension, and that those who earned very little during their working years must also remain poor as retirees. Most OECD countries don’t strictly use this way of calculating pensions and the pensions of low-wage earners, who have been working for years, are at higher levels. To make this system work, we would need a federal contribution that was a fixed percentage of the total expenditures on pensions.

Many people yearn for a big success, that can answer the pension question once and for all. The only problem is that this big success will not materialize.

 

The third reform on the agenda is about growing the numbers of people eligible under the statutory pension system. Full-time employees are compulsorily insured. There are three reasons to expand this group of people: firstly, eliminating unsatisfactory exemptions and therefore protecting taxpayers from having to make further welfare payments in the future; secondly, treating all payers into the system equally, and thirdly, ameliorating the impact of an aging population.

The existing system, which is compulsory, is a patchwork of measures, both with regard to its generosity and the way in which each measure is funded. The only people who are not subject to compulsory pension insurance are the self-employed, who are not members of one of 91 active pension schemes.

Lawmakers should make all of these self-employed people compulsory members of the statutory pension insurance fund, provided they are at an age that makes it possible to acquire significant claims. The expansion of the group of insured is urgent, as the numbers of self-employed will only increase with the digitization of production and administration. In contrast, compulsory insurance for the so-called solo self-employed would only provoke the search for loopholes.

In a country in which there is no compulsory pension system, a citizens’ insurance based on Switzerland’s Old Age and Survivors’ Insurance would make sense. However, the pension patchwork in Germany has grown over the decades and the claims on this system by payees are constitutionally protected.

Growing the numbers in the pension system would raise legal issues and would require a lengthy transition phase. In addition, measures that are not fully funded would require subsidization with public funds. This is why lawmakers are unlikely to be very interested in this. The third argument, for confronting problems resulting from demographic development by expanding the group of insured in the statutory pension insurance system, is only convincing in the short term. After this period is over, these additional revenues are offset by higher pension expenditures.

Many people – not least, many economists – yearn for a big success that can answer the pension question once and for all. The only problem is that this big success cannot, and will not, materialize.

Pension policy always reacts to changed preferences and both economic and demographic underlying conditions. It is always about distribution policy and always marked by the distribution standards of a changing political majority, which is in constant flux in any democracy.

As it happens, “justice” in a democracy is simply the respective diagonal in the parallelogram of political forces. Changes in the underlying conditions can consist of new official projections on population growth or distortions in the labor market.

 

The costs of German reunification were another factor. In a 1992 pension reform, benefits were significantly cut for the first time.

To understand the constraints and therefore the limits of government pension policy in Germany, you have to go back to the beginnings of postwar Germany. A few days ago, a successful model celebrated its 60th birthday, largely unnoticed by the public.

On the night of January 21, 1957, the pay-as-you-go “dynamic pension” was introduced, despite strong opposition from then-economics minister Ludwig Erhard and finance minister Fritz Schäffer, and against the votes of the pro-business Free Democratic Party.

As with any pension reform, three questions were asked at the time: Who should receive these benefits, how will the benefits change in the future and who should pay for the changes?

As to who was to be insured, the new system followed the lead of an invalid and old-age insurance under Prussian statesman Otto von Bismarck, which collapsed in the early 1920s. Only employees were considered in need of protection and subject to compulsory insurance.

In contrast to the Bismarck pension, introduced in 1892 and conceived as a fully-funded system, the new “dynamic pension” was to be a pay-as-you-go system funded primarily with current, wage-based contributions. This was the only way to pay a pension to those people nearing retirement age, and to adjust pension levels annually as wages increased. However, social redistribution within the pension system was largely ruled out. For this reason, pensions have been determined primarily on the basis of the principle of contribution equivalence ever since.

This pension reform was the most important social policy decision of the postwar era. As a result of raising the current pension by as much as 70 percent, old-age poverty, which had been rampant until then, suddenly disappeared.

An unintended consequence was that the conservative parties achieved an absolute majority, for the first and last time, in the 1957 parliamentary election. However, the current pension system would certainly not have been introduced at the time without the strong and labor-intensive economic growth of those years, without the emergence of the – admittedly inaccurate – Mackenroth theory, which states that in macroeconomic terms there is always only one pay-as-you-go system, without the faith in a birth rate always being higher than 2 percent and, finally, without the gigantic surpluses in the federal budget that were a consequence of a delayed expansion in the armed forces.

After this, there were pension reforms at irregular intervals. After further increases in benefits, the system came under pressure for the first time in the late 1970s, due to oil price crises and recessions. In the 1980s, falling birth rates made it increasingly clear that the German population would experience massive aging in the long term, meaning that pension cuts were unavoidable.

The costs of German reunification were another factor. In a 1992 pension reform, benefits were significantly cut for the first time. There would be 10 other major reforms from then on until today. Some were initially praised as “reforms of the century” but often, in reality, they didn’t even live beyond a legislative period.

In summary, it is clear that some kind of pension reform will happen during the next government. But it is also clear that it won’t survive two legislative periods. In a democracy, pension policy consists primarily of supplementary taxation in keeping with changes in underlying socioeconomic conditions, as well as ever-changing concepts of justice. And that is as it should be.

 

To contact the author: ruerup@handelsblatt.com

We hope you enjoyed this article

Make sure to sign up for our free newsletters too!