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Reforming an Unsustainable
Public Pension System:
The German Case
Anette Reil-Held
Mannheim Research Institute for the Economics of Aging (mea),
University of Mannheim, Germany

BPI Asset Management Conference on Pensions,
Lisbon, 18 March 2005
                             Outline:
0. The German Pension System
1. Problems and Challenges:
  - Ballooning dependency ratio of monolithic PAYG systems
  - Two dimensions of demographics change
  - Weak economic growth
2. Causes and Cures:
  - Growth: Stabilize contribution rates, foster prefunding
  - Babyboom/bust: Subtle shift between 1st and 2nd/3rd pillar
  - Longevity: Shift of retirement age
               History of the
           German Pension System
•   1880s: Bismarck installs funded system (ret.age=70)
•   1957: Adenauer converts to pay-as-you-go (ret.age=65)
•   1965: Indexation to gross wages
•   1972: Introducton of „flexible“ retirement age (effectively
          age 60) without actuarial adjustment
•   1992: Indexation to net wages,
          3.6% actuarial adjustments (starting from 2001!)
•   1999: Indexation to life expectancy (revoked in 2000)
•   2001: Riester Reform: Introduction of multipillar system
•   2003: Rürup Commission: Ret.age slowly increasing to 67,
          Indexation to system dependency ratio (NDC)
•   2004: Reform law to establish sustainability factor
      Main Features of the
     German Pension System
• Obligatory, designed to maintain the standard of
  living in retirement: ubiquitious!
• Pensions are roughly proportional to labour
  earnings over the whole working life
  („point system“)
• Only few redistributive properties:
       „pension insurance“

• Financed by contributions (19.5% of gross wages) and
  state subsidy (one third of pension expenditures)
                                    Outline:
0.   The German Pension System
1. Problems and Challenges:
     - Ballooning dependency ratio of monolithic PAYG systems
     - Two dimensions of demographics change
     - Weak economic growth
2.   Causes and Cures:
     - Growth: Stabilize contribution rates, foster prefunding
     - Babyboom/bust: Subtle shift between 1st and 2nd/3rd pillar
     - Longevity: Shift of retirement age
   ….and Old Age Dependency.


Italy   GER   Portugal   DK




                               15-64/65+
          Ballooning System Dependency
      Abbildung 4: Rentnerquotienten bei verschiedenen Erwerbsszenarien
       140%


  Pensioners
       130%


  Employees
       120%                                                                                                                          [125%]
       110%


       100%
                                                                                                                                         E 1

         90%                                                                                                                          90%E 2

         80%
                                                                                                                                         E 3


         70%                                                                                                                         [75%]
         60%



50%      50%

               95        00        05        10        15        20        25           30        35        40        45        50
          19        20        20        20        20        20        20           20        20        20        20        20
                                                                           J ahr




      Bemerkung: Die Kurven E1-E3 entsprechen den Erwerbsszenarien E1-E3 im Bevölkerungsszenario B2.
      Quelle: Birg und Börsch-Supan (1999)
            Demographic Change:
        1. Baby Boom/Bust Transition                                                          S c h a u b i l d 1 .6
               E n t w i c k l u n g d e r A l t e r s s t r u k tu r d e r B e völ k e r u n g i n d e n a l te n u n d n e u e n B u n d e s l än d e r n




                                                1997                                                                                                    2 02 5

       11 0                                                                                                   11 0


       10 0                                                                                                   10 0


        9 0                                                                                                     9 0




1997    8 0                                                                                                     8 0


        7 0


        6 0
                                                                                                                7 0


                                                                                                                6 0
                                                                                                                                                                                                                           2025
        5 0                                                                                                     5 0


        4 0                                                                                                     4 0


        3 0                                                                                                     3 0


        2 0                                                                                                     2 0


        1 0                                                                                                     1 0


          0                                                                                                       0

       -1 .0 0 0 .0 0 0   -5 0 0 . 0 0 0               0            5 0 0 .0 0 0      1.00 0.00 0              -1 .0 0 0 .0 0 0   -5 0 0 .0 0 0                 0            5 0 0 .0 0 0      1.00 0.00 0


       Män ne r ( n eue L.)      Män ner ( al te L.)       F rau en (n eu e L.)    F r aue n ( al te L.)      Män ner ( neu e L. )      M änn er (al t e L. )       F r aue n ( ne ue L.)    F rau en (a l te L. )




                                                20 5 0                                                                                                  2 10 0

       1 10                                                                                                   110

       1 00                                                                                                   100

         90                                                                                                      90

         80                                                                                                      80

         70                                                                                                      70

         60                                                                                                      60



2050     50

         40
                                                                                                                 50                                                                                                        2100
                                                                                                                 40

         30                                                                                                      30

         20                                                                                                      20

         10                                                                                                      10

           0                                                                                                       0
         - 1.00 0.00 0        -5 0 0 . 0 0 0           0             50 0.00 0        1.00 0.00 0                - 1.00 0.00 0       -5 0 0 . 0 0 0             0             50 0.00 0        1.00 0.00 0


       Män ne r ( n eue L.)      Män ner ( al te L.)       F rau en (n eu e L.)    F r aue n ( al te L.)      Män ner ( neu e L. )      M änn er (al t e L. )       F r aue n ( ne ue L.)    F rau en (a l te L. )


                                                                                                                                                B i r g / F l ö t h m a n n , I B S , U n i v . B i e l e fe l d 1 9 9 9
               Demographic Change:
           2. Increasing Life Expectancy
 89

 87
        Additional Benefits = Additional Financial Burden
             zusätzliche demographische Belastung durch den Anstieg
             der Lebenserwartung von Männern bzw. Frauen

 85
                                                             7   female
 83
Alter                                  4
 81

 79                                                              male
 77

 75
  1970        1980     1990     2000       2010     2020     2030       2040



                         Life expectancy 65 year old men
                         Life expectancy 65 year old women
        Weak Economic Growth

GDP growth rate:    GDP per capital level:
0. The German Pension System
1. Problems and Challenges
    -- Ballooning system dependency of monolithic PAYG systems
    -- Two dimensions of demographic change
    -- Weak economic growth

2. Causes and cures:
   Keep public systems, foster private savings
    1. Growth: Stabilize contribution rates
    2. Babyboom/bust: Partial transition to more funding
    3. Longevity: Shift of retirement age
 Increasing taxes/contributions is no
  solution in the large EU countries:
International Labour Costs per hour in Euro
1. Growth: Stabilize Contribution Rate

          26                                                  25,450
          25      48,2                            24,1
          24                                                          48
          23




                                                                           Prozent
Prozent




          22               45,2                                       46
          21                             21,3
          20                             43,9                         44
          19      19,3     19,4                   42,0
          18                                                  40,942
          17
          16              2010        2020
                         Beitragssatz (linke Skala) 2030              40
               2000                                  Skala)
                         Bruttorentenniveau (rechte 2030
                         2010          2020                    2040


                                    Need Benefit Cuts!
 2. Babyboom/bust: DB->NDC (demography
         indexed PAYG), Prefunding                                                            S c h a u b i l d 1 .6
               E n t w i c k l u n g d e r A l t e r s s t r u k tu r d e r B e völ k e r u n g i n d e n a l te n u n d n e u e n B u n d e s l än d e r n




                                                1997                                                                                                    2 02 5

       11 0                                                                                                   11 0


       10 0


        9 0
                                                                                                              10 0


                                                                                                                9 0
                                                                                                                                                                                                         Solution:
1997                                                                                                                                                                                                     Partial
        8 0                                                                                                     8 0


        7 0                                                                                                     7 0
                                                                                                                                                                                                              2025
                                                                                                                                                                                                         funding
        6 0                                                                                                     6 0


        5 0                                                                                                     5 0


        4 0                                                                                                     4 0




                                                                                                                                                                                                         (pillars
        3 0                                                                                                     3 0


        2 0                                                                                                     2 0


        1 0                                                                                                     1 0


          0

       -1 .0 0 0 .0 0 0   -5 0 0 . 0 0 0


       Män ne r ( n eue L.)      Män ner ( al te L.)
                                                       0            5 0 0 .0 0 0


                                                           F rau en (n eu e L.)
                                                                                      1.00 0.00 0


                                                                                   F r aue n ( al te L.)
                                                                                                                  0

                                                                                                               -1 .0 0 0 .0 0 0


                                                                                                              Män ner ( neu e L. )
                                                                                                                                  -5 0 0 .0 0 0


                                                                                                                                        M änn er (al t e L. )
                                                                                                                                                                0            5 0 0 .0 0 0


                                                                                                                                                                    F r aue n ( ne ue L.)
                                                                                                                                                                                                         2 and 3)
                                                                                                                                                                                               1.00 0.00 0


                                                                                                                                                                                             F rau en (a l te L. )




                                                20 5 0                                                                                                  2 10 0

       1 10                                                                                                   110

       1 00                                                                                                   100

         90                                                                                                      90

         80                                                                                                      80

         70                                                                                                      70

         60                                                                                                      60



2050     50

         40
                                                                                                                 50                                                                                                        2100
                                                                                                                 40

         30                                                                                                      30

         20                                                                                                      20

         10                                                                                                      10

           0                                                                                                       0
         - 1.00 0.00 0        -5 0 0 . 0 0 0           0             50 0.00 0        1.00 0.00 0                - 1.00 0.00 0       -5 0 0 . 0 0 0             0             50 0.00 0        1.00 0.00 0


       Män ne r ( n eue L.)      Män ner ( al te L.)       F rau en (n eu e L.)    F r aue n ( al te L.)      Män ner ( neu e L. )      M änn er (al t e L. )       F r aue n ( ne ue L.)    F rau en (a l te L. )


                                                                                                                                                B i r g / F l ö t h m a n n , I B S , U n i v . B i e l e fe l d 1 9 9 9
               Index to System Dependency
      Abbildung 4: Rentnerquotienten bei verschiedenen Erwerbsszenarien
       140%


  Pensioners
       130%


  Employees
       120%                                                                                                                          [125%]
       110%


       100%
                                                                                                                                         E 1

         90%                                                                                                                          90%E 2

         80%
                                                                                                                                         E 3


         70%                                                                                                                         [75%]
         60%



50%      50%

               95        00        05        10        15        20        25           30        35        40        45        50
          19        20        20        20        20        20        20           20        20        20        20        20
                                                                           J ahr




      Bemerkung: Die Kurven E1-E3 entsprechen den Erwerbsszenarien E1-E3 im Bevölkerungsszenario B2.
      Quelle: Birg und Börsch-Supan (1999)
        2. Babyboom/bust:
Demography-indexed PAYG and Funding
General idea of system with “sustainability
factor”:
Budget equation of a PAYG system:
cont_rate  wage  NWORK = repl_rate  wage  NPENS

Hold cont_rate = repl_rate  NPENS/NWORK = constant!

 repl_rate has to be proportional to NWORK/NPENS

                           System dependency ratio
          2. Babyboom/bust: Demography-
              indexed PAYG and funding
Annual                Change in earnings,                       Change in system
Pension               net of contributions                      dependency ratio
Increase
                      (aggregate, lagged)                       („sustainability factor“)
                      AGE t 1 1  CONT 1t 1  CONT 2 t 1           SDR t 1
 APV t  APV t 1 *            *                               * [(1-          ) * +1]
                      AGE t  2 1  CONT 1t  2  CONT 2 t  2        SDRt  2
 where:
  APV = average pension value
  AGE = average gross earnings
  CONT1,2 = contribution to first and second pillar
  SDR = system dependency ratio (number of equivalence pensioners / number of equivalence contributors)


                                   The German pension indexation formula
        Babyboom/bust:
 Fill gap with private pensions
                                          60%
                                                                                                               R ie s te r - R e n te b e i e in e m

                                          55%
                                                              R ie s te r - R e n te b e i e in e m
                                                                                                               N o m in a lz in s v o n 6 %
                                                                                                                                                                                                    Funded pillars
                                                                                                                                                                                                    2 and/or 3 at a
                                                              N o m in a lz in s v o n 4 %
                                          50%

48%                                       45%
                                                                                                                                                                                                    4% saving rate
                                          40%
                                                                                                                                                                                                    (return = 4% /
      Br u t t o r e n t e n n iv e a u




                                          35%
                                                                                                                                                                                                    6%)
                                          30%




                                                                                                                                                                                                    PAYG pillar 1
                                          25%

                                                                       R e n te n n iv e a u d e r g e s e tz lic h e n


                                                                                                                                                                                                    reduced by
                                          20%
                                                                       R e n te n v e r s ic h e r u n g n a c h Ein f ü h r u n g d e s
                                                                       N a c h h a ltig k e its f a k to r s


                                                                                                                                                                                                    sustainability
                                          15%


                                          10%


                                          5%
                                                                                                                                                                                                    factor
                                          0%
                                                2002

                                                       2004

                                                                2006

                                                                         2008

                                                                                 2010

                                                                                        2012

                                                                                                2014

                                                                                                        2016

                                                                                                               2018

                                                                                                                      2020

                                                                                                                             2022

                                                                                                                                     2024

                                                                                                                                            2026

                                                                                                                                                   2028

                                                                                                                                                          2030

                                                                                                                                                                 2032

                                                                                                                                                                        2034

                                                                                                                                                                               2036

                                                                                                                                                                                      2038

                                                                                                                                                                                             2040
                                                                                                                      Jah r e
 …if there were only sufficient time:
   Room for Prefunding
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
 0%
       E      D            F     I        GB   NL        US     CH

           Public Pillar       Occup. Pillar   Private Pillar
How to fill the gap, the 2nd pillar

2nd pillar: Promotion of occupational pensions

- Traditionally played a minor role in Germany
=> Introduction of additional subsidies were introduced
    with the „Riester reform“:
    - general right to convert part of the salary into
      contributions to pension plans for each worker
    - pension funds are now eligible for subsidies/tax relief
==>successful: broader coverage (2001-2003: +14%)
      How to fill the gap, the 3rd pillar


                                Successful?
                                Don‘t know
                                yet ...
50%
3. Longevity: Increase Retirement Age
      (Can‘t do all by savings ...)
Very unpopular
 late start (2011), slow phase-in (1 month p.a. until 2035)
Current high unemployment
 cause and effect?
 have a regular check of labor market situation
 put pressure on employers
Worn-out argument
 see 1960-72; since then four (healthier) life years more,
  until 2035 another three years
Effective vs. statutory retirement age; expectational
effects
actuarial adjustments are absolutely necessary
Increase earliest retirement age
                          Where do we stand?
The most pressing pension problems
have not been resolved in *any* of the
four large continental EU countries:
- Neither dimension of demographic change fully addressed
 Ballooning contribution rates
 Weak economic growth
Four essential reform steps (GER):
x. Growth: Raising contribution rates is not an option
1. Babyboom/bust: Change PAYG systems from DB to DC 
2. Fill gap with private savings (natural limits): tbd
3. Longevity: Shift of early and normal entitlement ages: tbd

				
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