Germany: Selected Issues

This Selected Issues paper analyzes labor market asymmetries and macroeconomic adjustment in Germany. Empirical work reported shows that in Germany, negative demand shocks increase the unemployment rate by more than the decrease in the unemployment rate caused by a comparable-sized positive demand shock. The contribution of labor costs to explaining the high level of unemployment, particularly since unification, is studied. Empirical estimates are obtained for the wage gap—the deviation of actual labor costs from warranted labor costs based on estimated production functions assuming competitive factor markets and full employment.

Abstract

This Selected Issues paper analyzes labor market asymmetries and macroeconomic adjustment in Germany. Empirical work reported shows that in Germany, negative demand shocks increase the unemployment rate by more than the decrease in the unemployment rate caused by a comparable-sized positive demand shock. The contribution of labor costs to explaining the high level of unemployment, particularly since unification, is studied. Empirical estimates are obtained for the wage gap—the deviation of actual labor costs from warranted labor costs based on estimated production functions assuming competitive factor markets and full employment.

V. Alternative Approaches to Pension Security in an Aging Society1

Introduction and Summary

197. This chapter discusses three approaches to public pension reform in the context of recent proposals to overhaul Germany’s pay-as-you-go (PAYG) scheme. First, the “piecemeal approach” to pension reform focusses on adjusting the basic parameters affecting public pension revenue and expenditure, such as the contribution rate, budget transfers, pension replacement rates, or retirement ages. Second, partial prefunding of the public pension pillar, an approach that allows to smooth contribution rates across contributing generations. And third, shifting a significant portion of retirement income provision to a funded private pension scheme, thus diversifying pension provision between the public and private sector.

198. The pension reform proposals by a commission chaired by Labor Minister Blüm—which were broadly incorporated in a draft pension law submitted to the Bundestag in June 1997—followed the piecemeal approach of earlier German reform efforts, and proposed to cut net pension replacement rates, to increase budget transfers, and to tighten the generosity of early retirement and disability pensions. These proposals would preserve the dominant role of the public PAYG pillar. Indeed, in its report, the Blüm Commission strongly advised against considering alternative approaches to pension reform that would lead to fundamental or systemic changes to Germany’s present pension system—including partial prefunding and shifting a significant portion of retirement income provision to a funded private pension scheme—arguing that the PAYG system has proven sturdy and adaptable under difficult historical circumstances and that the transition cost of systemic reforms would not be manageable.

199. The chapter concludes that regarding pension reforms, policy makers can not eschew difficult trade-offs involving risk, equity, and efficiency considerations. However, a prudent pension reform strategy seeking to adapt a pension system dominated by a large PAYG pillar to the challenges of an aging society would seek to combine elements of all three approaches to pension reform:

• Piecemeal adjustments in existing public pension arrangements, in particular of benefit structures, are often needed as a first step to improve the short-run fiscal position of public pension funds and to prepare the grounds for systemic reform. The piecemeal adjustments proposed by the Blüm Commission are sensible both on equity and efficiency grounds. However, a pension reform strategy exclusively based on piecemeal adjustments of PAYG parameters—while perhaps politically expedient—would continue to subject pensioners and contributors to considerable long-run risks by not addressing most of the problems associated with a pension system dominated by a PAYG pillar, in particular in the context of a rapidly aging population.

• Partial prefunding of the public pension scheme could mitigate intergenerational inequities by smoothing contribution rates across contribution generations and enhance financial discipline. At the same time, partial prefunding as an isolated strategy can not address the various problems plaguing a pension system dominated by a large PAYG pillar. Moreover, partial prefunding of the first pension pillar could raise difficult financial management issues given the need to accumulate a large pension reserve fund within the confines of the public sector.

• Shifting a significant portion of retirement income provision to a funded private pension pillar could address most of the risk and efficiency concerns raised by Germany’s present system. However, these gains would likely come at the cost of incurring a sizeable explicit fiscal burden during the transition period. This burden would need to be distributed equitably across generations. Moreover, government insurance of private pension funds would raise complex regulatory issues.

200. Thus, the range of choices and trade-offs for pension reforms is considerable. At the same time, the time available for designing and implementing more systemic reforms is fast running out. While the full impact of the aging problem is not likely to be felt for another 10-15 years, the lead time for systemic changes in pension arrangements are long and to avoid sizeable costs, early reforms are needed. As regards the eventual structure of Germany’s pension system after adopting the multi-pronged reforms outlined above, it would likely bear close resemblance to Switzerland’s present pension system featuring a sizeable first-pillar social insurance scheme that would pay a basic pension benefits, a funded private second-pillar scheme that would pay complementary pensions aiming to achieve a satisfactory pension replacement rate, and a third-pillar scheme consisting of voluntary savings.

201. Section A provides institutional background information on the German pension system and lays out the mechanics of PAYG financing. Section B considers the piecemeal approach to pension reform, focussing on the Blüm Commission’s reform proposals. Finally, Section C discusses systemic approaches to pension reform.

A. Institutional Background and the Mechanics of PAYG Financing2

202. Since the pension reform of 1957, the provision of retirement income in Germany has been dominated by a mandatory publicly-managed PAYG pension scheme.3 Under the present PAYG scheme, an average wage earner with a full contribution record of 45 years is promised a pension benefit equivalent to about 70 percent of average net earnings. Reflecting the wide coverage and high income replacement rates of this first pension pillar, retirement income provision through voluntary private pension schemes, or the second pension pillar, has traditionally played a relatively minor role. Indeed, the intergenerational contract underpinning the PAYG scheme has often been hailed as one of the cornerstones of Germany’s social market economy (Soziale Marktwirtschaft): a market economy restrained by social policies that include among their main instruments comprehensive and publicly-managed pension, health, and unemployment insurance systems.

203. Total spending by the first pillar of the German pension system in 1994 amounted to about 13 percent of GDP, one of the highest public pension spending ratios among industrial countries (Chart V-1). Spending by the wage and salary earners’ fund (WSEF), at about 10 percent of GDP in 1994, and the civil service pension scheme, at about 2 percent of GDP in 1994, accounted for almost all of public spending on pensions. The WSEF covers about 98 percent of wage and salary earners. As the civil service pension scheme is subject to different demographic and financial influences, the WSEF will be assumed to coincide with the first-pillar system.4

Chart V-1
Chart V-1

Industrial Countries Public Pension Expenditure As a Percent of GDP

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A005

Source: World Bank (1994).

204. The key parameters of the WSEF can be brought out by considering the basic budget constraint of a PAYG system:

(1)N(αW)=M(βW),

where N denotes the number of contributors to the system, α is the contribution rate, W denotes average gross earnings, M is the number of retirees (pensioners), and β denotes the gross pension replacement rate. equation (1) says that revenue and expenditure of PAYG system have to match in each period.5 To model Germany’s public pension system, two important institutional characteristics need to be incorporated in equation (1):

• First, pensions are indexed to net wages; this feature may be handled by re-defining β as the net pension replacement rate, here defined by the pension expressed as a ratio to net wages, W(1-α). However, this definition of the net pension replacement rate represents only an approximation. In practice, the average net wage is defined as average gross wage minus the employee’s social security contributions, which also include contributions to health care, unemployment, and long-term care insurance and minus wage income tax. By taking account of both the employee’s and the employer’s share of the social security contribution, savings from net wage indexation are overstated. On the other hand, the built-in progressivity of the income tax schedule—rather than the implicitly assumed flat tax schedule—would lower pension costs under the assumption of rising wage incomes. On balance, the approximation appears to be reasonable.

• Second, the revenue of the PAYG system consists of contributions by workers plus a budget transfer component. Budget transfers are supposed to broadly cover the share of WSEF spending unrelated to previous pension contributions. However, calculations recently reported by the Association of German Pension Insurance Funds (1997) estimated WSEF spending unrelated to previous contributions in 1995 at 30 percent of total WSEF spending, significantly higher than the about 18 percent of WSEF spending actually covered by budget transfers.6 The main categories of spending unrelated to previous contributions in 1995 were: (i) pension payments based on imputed World War II contribution periods, which accounted for 23 percent of total unrelated spending; (ii) cost of early retirement pensions not covered by actuarial pension reductions (18 percent); (iii) imputed contribution periods for times spent unemployed or sick (15 percent); (iv) imputed contribution periods for times spent in education (8 percent); and (v) the cost of imputed contribution periods due to raising children (6 percent).

205. Taking account of net wage indexation and expressing the budget transfer component as a ratio to pension expenditure (t), the PAYG system’s equilibrium contribution rate can be written as:

(2)α=β(M/N)(1α)(1τ).

206. The 1994 data for the WSEF can be used to calibrate values of parameters in equation (2) (Table V-1, column “1994”). The system dependency ratio (M/N) of the WSEF in 1994 was about 41 retirees per hundred contributors. The net replacement rate (β) for a “standard pension” was about 70 percent. Given the budget transfer rate (τ) of 18 percent in 1994, the implied PAYG system contribution rate is 19.2 percent, which, by construction, is equal to the statutory contribution rate of the WSEF in 1994.

Table V-1.

Germany: Public Pension Projections and Blüm Commission Reform Proposals, 1994-2030

(In percent)

article image
Sources: Blüm Commission Proposals (1997); Verband Deutscher Rentenversicherungsträger (VDR); and staff estimates.

Wage and salary earners’ pension fund (WSEF) only. Projections incorporate late-1996 (WFG) changes to pension law..

Defined as ratio of number of pensioners to number of contributors.

Defined as ratio of standard pension as a percent of average net wage.

Defined as budget contribution to pension fund as a percent of pension expenditure.

Statutory contribution rate.

Defined as population aged 65 and over as a percent of population aged 15-64.

207. First-pillar pension benefits are in principle subject to income tax, a feature that could also be incorporated in equation (2) to determine the net cost of public pension provision. However, Germany’s present income tax code assumes that only about 25 percent of pension benefits represent previously untaxed income, which, in practice, amounts to a full income tax exemption. The assumption that only about 25 percent of public pension benefits represent previously untaxed income is based on two presumptions: (i) that all pension contributions were previously subject to income tax; and (ii) that pension benefits include a tax-free interest income component equivalent to about 25 percent of benefits. However, in fact only the employee’s pension contribution is subject to income tax, and, as illustrated below, the rate of return on pension contributions is significantly below market interest rates on long term government bonds. The draft law on income tax reform proposed to increase the taxable share of pension benefits to 50 percent. However, this change in the income tax law would leave most public pension benefits exempted from income tax, therefore obviating the need to incorporate income taxation in equation (2).

208. At unification, former west Germany’s first-pillar system was also introduced in the new Länder. Pension benefits in the new Länder at the beginning of 1996 were 81 percent of the level in the old Länder and are indexed to wage developments in the new Länder. The first-pillar pension insurance schemes are supplemented by means-tested social assistance and housing benefits, which, in the case of a single-person household, cumulatively replace about 40 percent of the average net wage in the economy. Take up of re-current social assistance by elderly persons is, however, modest; at the beginning of the 1990s, only about 1 percent of all persons aged 65 or more received re-current social assistance transfers.7

209. The second or occupational pension pillar of the German pension system comprises voluntary company pension plans, which are either funded by book reserves on companies’ balance sheets, by separate pension funds (Pensionskassen), by support funds (Unterstützungskassen), or by insurance policies taken out by companies on the employee’s behalf. A Deutsche Bank study (1996) reported that assets of occupational pension schemes in 1993 amounted to DM 461 billion or 14.6 percent of GDP, of which about 55 percent were kept as book reserves on companies’ balance sheets. Pension funds accounted for about 23 percent of occupational pension assets. The dominance of book reserve funding for occupational pensions in Germany reflects partly the more favorable income tax provisions for accumulating book reserves—employers’ contributions channeled into book reserves are not taxable whereas employers’ contributions to pension funds are taxable—but may also be due to Germany’s distinct “stakeholder culture.”

210. Insolvency insurance for occupational pensions is provided by a mutual insurance corporation that has the powers of an institution of public administration. The liabilities of the mutual insurance corporation are backed up by a state guarantee, and it is financed on a PAYG basis by compulsory contribution rates. The coverage of employees by occupational pension schemes has declined since the mid-1980s, in particular in the industrial sector, reflecting inter alia a steady worsening of tax preferences and the cost impact of judicial decisions requiring the indexation of pension payments.8 Available, but sketchy, data on the size of private funded pension schemes in selected industrial countries suggest that Germany’s second-pillar system is comparatively small, mirroring the overarching importance of the first-pillar system.9

211. The third pension pillar, individual provisions for retirement, plays a substantial role, as indicated by a comparatively high private household savings rate of about 13 percent during 1991-96 and net asset holdings of about 470 percent of disposable household income in 1992.10 Fiscal incentives to promote individual retirement savings directly or indirectly include income tax exemptions for private household life insurance savings, a tax allowance for income from capital assets, and income tax incentives for the acquisition of owner-occupied housing.

B. The Piecemeal Approach to Pension Reform

212. The traditional approach to pension reform in Germany—as in most other industrial countries—has consisted in piecemeal adaptations of the basic parameters determining revenues and expenditures of the public pension system. As the most recent occurrence of substantial piecemeal pension reforms in Germany, the 1992 Pension Reform Act introduced: (i) a gradual unification of statutory retirement ages for regular pensions at age 65; (ii) the linking of pensions (new and pre-existing pensions) to net instead of gross wages, thereby stabilizing the average pension benefit at a net replacement rate of about 70 percent; and (iii) introduction of flexible early retirement of up to three years before the statutory retirement age with a reduction of benefits of 3.6 percent per year of early retirement. According to projections, in the absence of these measures the pension contribution rate could have risen to about 3614 percent in 2030, up by more than 18 percentage points from a level of about 18 percent in the early 1990s; taking account of the 1992 pension reform, the calculations predicted an equilibrium contribution rate in the range of 26-28 percent in 2030.11 At the time of the 1992 reform, the projected long-run increase of the contribution rate was widely characterized as a necessary element of a “fair burden sharing” compromise between contributors and pensioners.

213. In the event, only a few years after the adoption of the 1992 Pension Reform Act and with hardly any change in the long-term outlook for the pension finances, the government decided to put pension reform back on the public policy agenda in early 1996. In particular, the Action Program for Jobs and Investment (“50-point program”) called, inter alia, for a major overhaul of social spending, including spending on public pensions, to curb rising non-wage labor costs. The Action Program referred to increasing global competition and deteriorating labor market conditions as the main rationales for reconsidering the 1992 “burden sharing compromise.” Given this shift in priorities, a fresh round of reforms was needed to address the immediate problem of reducing (or at least limiting further increases) in the pension contribution rate during 1997-2000 12 as well as the long-term problem of limiting increases in the pension contribution rate below the levels projected under the 1992 reforms.

214. A first package of piecemeal pension reform measures was enacted as part of the Law on Promotion of Growth and Employment (WFG) in September 1996. These measures included: (i) an accelerated increase of the statutory retirement age for women and long-term unemployed persons from 60 to 65 years; (ii) an accelerated increase of the statutory retirement age for long-term insured persons from 63 to 65 years; (iii) recognition of only 3 years (before 7 years) of education as non-contributory periods; and (iv) cash limits on rehabilitation spending for pensioners. Estimates suggest that—relative to a baseline based on the 1992 pension reform—these measures would lower the need for increases in the contribution rate by 0.4 percentage points in 2000 and by almost 1 percentage point by the year 2010.13

215. In June 1996, the Government appointed a commission on “Further Developing the Pension System” chaired by Labor Minister Blüm.14 The Commission’s baseline projection of the WSEF finances suggested that projected increases in the system dependency ratio would eventually raise the pension contribution rate to about 26 percent in 2030, some 7 percentage points above its 1996 level, with most of the increases in the contribution rate occurring after 2010 when the “baby boom” generation begins to retire (Table V-1). This projection assumes that the pension for a worker with average earnings and 45 contribution years would continue to replace about 70 percent of net wage earnings and that budget transfers would continue to finance about 18 percent of total pension expenditure, but rising from presently about 1¾ percent of GDP to 2¼ percent of GDP in 2030.

216. The Blüm Commission’s report addressed the concerns raised by the government’s Action Program through three main piecemeal reform proposals, which were broadly incorporated in the draft pension law (Rentenreformgesetz 1999) submitted to the Bundestag in June 1997 (see Table V-1 for the effects of the proposals on the Commission’s baseline projection of pension contribution rates during the period 2000-30):15

• A phased-in cut in the net pension replacement rate (β) to reflect increases in longevity of 65-year old persons (averaged for men and women) since the 1992 pension reform.16 In particular, from about the year 2000 onwards, pension benefits would be lowered by one half of the percentage point increase of life expectancy of 65-year old persons. As the average life expectancy of a 65-year old person in Germany is presently estimated at about 17 years and is projected to increase until 2030 by about 2 years, this measure is estimated to amount to a cumulative cut in net pension benefits of about 5 percent relative to baseline by 2030. Accordingly, this measure would eventually reduce the standard net pension replacement rate by about 5 percentage points to 64 percent and reduce the 2030 contribution rate by 1½ percentage points.

• An increase in budget transfers of about ½ percentage point of GDP starting in 1999. The Blüm Commission had proposed this measure as an explicit compensation for the accrual of new non-contributory pension rights related to raising children. However, the draft pension law submitted to the Bundestag does not tie the increase in budget transfers to this specific purpose.17 This measure is projected to increase the budget transfer rate from 18 percent at present to 22½ percent of pension expenditure by 2000, and it would contribute 1 percentage point to the lowering of the 2030 contribution rate.

• And a tightening of the current generosity of early retirement pensions due to prolonged unemployment and of disability pensions for severely handicapped persons. The Blüm Commission estimated this measure to contribute about 14 percentage point to the lowering of the 2030 contribution rate. However, more recent estimates by the Association of German Pension Funds gauged the reduction in the 2030 contribution rate at about 1 percentage point.

217. Overall, the proposed three measures were projected to lower the 2030 contribution rate by a total of 3 percentage points; in the “short-run”, i.e. by the year 2000, the three measures would lower the projected contribution rate by some 1¼ percentage points, but this contribution rate reduction would mainly reflect the substitution of budget transfers for revenue from social security contributions.18

218. The Blüm Commission’s report strongly supports the preservation of the four main structural characteristics of the German pension system:

• The dominance of the PAYG pension pillar would remain largely intact, leaving residual roles to retirement income provision through funded occupational schemes or individual saving.

• The financing of first-pillar pension benefits according to PAYG principles, as opposed to partial or full funding.

• The relatively close link between worker contributions and pension benefits, which limits the redistributive role of the public pension system.

• And the indexation of pension benefits to net wages, as opposed, to indexing pension benefits to consumer prices or gross wages.

219. Besides achieving the key goal of reducing the need to increase social security contribution rates, the piecemeal proposals would further strengthen the already close link between contributions and benefits under Germany’s first-pillar system. In particular, these proposals would establish a link between changes in life expectancies and pension benefits, increase the share of non-insurance related pension financed by budget transfers, and reduce the generosity of early retirement and disability pensions. Nevertheless, the Commission’s overall recommendation to maintain the dominance of the present PAYG pillar raises issues of risk, equity, and efficiency of long-run retirement income provision in Germany:

220. Risks: Long-term projections of pension finances are always subject to large margins of uncertainty. Nevertheless, the Commission’s baseline projection for the system dependency ratio appears to be based on a fairly optimistic scenario. In particular, the Commission’s projections broadly follow the “upper (i.e. optimistic) variant” of the Prognos-Gutachten 1995 (1995) study of Germany’s long-term public pension finances adjusted for the 1996 WFG-changes to the pension laws.19 The upper Prognos variant assumes that population aging will partly be kept in check by higher net immigration (about 200,000 persons per year during 2010-30, an assumption that would increase the share of foreigners as a percent of the total population in Germany from 8 percent in 1992 to 23 percent in 2030). Moreover, the upper Prognos variant projects further significant increases in the labor force participation rate of women in the old Länder and a long-term decline of the unemployment rate to an average level of 4½ percent from an average of 9¼ percent during 1992-96.

221. As an alternative benchmark, staff projections based on the World Bank’s population projections for Germany, which assume zero net immigration after 2005, suggest that the system dependency ratio would about double by 2030 (Table V-1 and Chart V-2).20 The staff projections also reflect the assumptions of broadly unchanged labor force participation and unemployment rates, the latter fixed at about 8 percent, corresponding broadly to a “consensus estimate” of the natural rate of unemployment for Germany. Moreover, pension eligibility rates are assumed to be constant during the projection period except for adjustments reflecting the phasing-in of retirement age increases scheduled by the WFG passed in 1996.21 The staffs projection of the system dependency ratio essentially reflects the trend increase in the elderly dependency ratio during the period 2010-30. Under the additional assumptions of unchanged net replacement and budget transfer rates, the staffs projections would necessitate an increase in the contribution rate of the WSEF to about 31 percent by 2030, some 5 percentage points more than in the Blüm Commission’s baseline. At the same time, over the next 15 years or so, the projected contribution rate under the two baselines are similar, deviating from each other only by about ½ percentage point in 2010.

CHART V-2
CHART V-2

Germany Demographic and System Dependency Ratios

(In Percent)

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A005

Sources: Verband Deutscher Rentenversicherungstraeger (VDR); Bluem Commission proposals (1997); and staff estimates.1/ Defined as population aged 65 and over as a percent of population aged 15–64.2/ Defined as number of “standard pensioners” as a percent of number of contributors.

222. The long-run projection risk built into the Commission’s baseline projection exposes contributors to the risk of significantly higher-than-projected contribution rate increases, or, alternatively, pensioners to the risk of significantly lower-than-projected pension replacement rates.22 The issue of projection risk also highlights the small margin of manoeuvre inherent in the Commission’s decision to adopt a piecemeal reform approach. In particular, at least for low and average income earners, it would probably be difficult to reduce pension replacement rates much further without recourse to systemic reform that would include the build-up of a significant second-pillar system. Indeed, analysis suggests that first-pillar systems broadly fall into the two categories “large” and “small” systems, corresponding roughly to average replacement rates of around 60-70 percent and around 30-40 percent, respectively. This discontinuity in the size of first-pillar systems across industrial countries may reflect the need for a “critical mass” in order to build up a significant funded private pension scheme, perhaps related to the relatively high administrative cost of funded schemes or to decreasing welfare gains from social insurance at higher pension replacement rates.23

223. Equity: The acceptability of a PAYG system to workers and pensioners depends, inter alia, on the system’s net benefit payments to different generations taking account of lifetime contributions and benefits (intergenerational equity) and the system’s rate-of-return characteristics for contributors within a given cohort (intragenerational equity). An increase in the system dependency ratio will, in general, lower the net benefits of cohorts that retire later; these cohorts pay into the system at a time of rising contribution rates, while their net replacement rates may decline. This prediction regarding intergenerational equity is clearly borne out by calculations for the WSEF fund. Based on the staffs projection of the system dependency ratio, net pension benefits of a representative pensioner—measured by lifetime benefit-contribution (“money worth”) ratios or, alternatively, by the real internal rate of return—of cohorts retiring after 1995 decline sharply over time (Chart V-3). For example, staff calculations indicate that the real internal rate of return of a pensioner retiring in 1995 amounted to about 2½ percent, but it would decline to below ½ percent for a pensioner retiring in 2030. For comparison, the real rate of return on long-term government bonds during 1970-96 amounted to about 4½ percent (CPI adjusted). The Blüm Commission’s proposals would have only a marginal (equalizing) effect on the lopsided intergenerational distribution of net benefits (Chart V-3).

CHART V-3
CHART V-3

Germany Intergenerational Equity Implications of Public Pension System 1/

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A005

Source: Staff estimates.1/ Wage and salary earners’ fund; average wage earner with average life expectancy (both sexes) at age 65 and 45 contribution years; real wage growth of 2 percent; and real interest rate of 3 percent.

224. The relatively low and declining internal rate-of-return characteristics of a PAYG pension system in the face of an aging population also raise an intragenerational equity issue. Pension contributions on wage earnings are subject to a ceiling of about twice average wage earnings (DM 98,400 per annum in 1997). High-income wage earners with incomes exceeding the ceiling (and the same applies a fortiori to self-employed persons not participating in the system) have the option to invest a proportional share of their income in excess of the contribution ceiling in assets with significantly better rate-of-return characteristics than offered by the PAYG pension system. As a consequence, the rate of return on the same percentage share of income set aside for retirement income provision could be significantly tilted in favor of high-income earners.24

225. Efficiency: The efficiency implications of large first-pillar systems for savings, investment, and work effort have been at the focus of a large recent literature on pension reform.25 While the savings implications of PAYG versus funded pension systems remain controversial,26 a substantial body of evidence indicates that large first-pillar pension systems are often associated with significant labor market distortions and/or narrower equity markets. As regards potential labor market distortions, recent studies have highlighted: (i) the role of high pension contribution rates in raising effective marginal tax-benefit rates at lower income levels; (ii) the distortions due to a loose link between contributions and benefits; and (iii) the adverse effects on labor force participation rates of elderly cohorts.27

226. Pension contributions, in combination with other social security contributions, account for a significant portion of high effective marginal tax-benefit rates at lower income levels in Germany. As mentioned above, the Commission’s reform proposal were largely motivated by concerns that further sizeable increases in pension contribution rates could impair the competitiveness of the German economy and increase distortions in the labor market. However, the Commission’s proposals would probably not have a significant impact on effective marginal tax-benefit rates in the short run, in particular if indirect taxes are incorporated in the tax-benefit wedge measures. In the long run, the proposals would—under the Commission optimistic baseline projection—allow for a further long-term increase in the pension contribution rate by 3 percentage points.

227. In view of the already relatively tight link between pension contributions and benefits, Germany’s first-pillar system is likely to be subject to fewer distortions from the tax-benefit wedge caused by the pension contribution rate. As already mentioned, the Commission’s three main proposals would further strengthen the link between contributions and benefits. As regards the impact of the public pension system on labor force participation of elderly cohorts, large first-pillar systems are generally associated with lower labor force participation rates for persons aged 55-64 years (Chart V-4). This could reflect formal early retirement provisions,28 but may also reflect political pressures to use the public pension pillar to reduce measured unemployment among older workers. The reforms announced in the 1996-WFG pension reforms and the Commission’s proposals on disability pensions would tighten formal early retirement provisions. At the same time, the Blüm Commission—citing the insurance purpose of the public pension system—advised against introducing actuarially fair pension benefit reductions for early retirement.

Chart V-4
Chart V-4

Industrial Countries Public Pension Expenditure and Labor Force Participation Rates of 55-64 Year Old Persons

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A005

Sources: World Bank (1994) and International Labor Statistics (1993).

228. Lack of venture capital is often cited as a key financial bottleneck for the growth of businesses in Germany.29 Indeed, cross-country data on the size of first-pillar systems and stock market capitalization suggest that large first-pillar systems are usually associated with relatively narrow equity markets (Chart V-5). While the lack of an “equity culture” in countries with large first-pillar systems could reflect a host of other influences including tax, investment, and accounting rules, risk-averse investment attitudes, and financial market regulations, there appears to be evidence that these other influences usually “fall in place” once a significant funded private pension pillar is built up.

Chart V-5
Chart V-5

Industrial Countries Public Pension Expenditure and Stock Market Capitalisation As a Percent of GDP

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A005

Sources: World Bank (1994) and Deutsche Bundesbank (1997).

C. Systemic Pension Reform Approaches

229. The Blüm Commission’s report argued strongly in favor of maintaining the basic structure of the present pension system. Nevertheless, pressures for adopting more systemic approaches to pension reform in Germany have been mounting.30 As indicated above, four considerations appear to underpin the case for more systemic pension reform in Germany:

• The scope for further piecemeal reforms is limited by the likely need to preserve net replacement rates for the mass of retirees in the range of 60-65 percent and the constraints on increases in the contribution rate. Options for further piecemeal reforms include reductions in pension spending not related to previous contributions, in particular by moving to actuarially fair pension benefit reductions for early retirement (as indicated this measure could allow a reduction in the contribution rate of some ¾ of a percentage point) and by further cutting imputed pension contribution periods for time spent in education. Indexing pensions to the CPI, rather than to net wages as at present, could lower spending on pensions in the likely case that future CPI inflation is lower than net wage increases. The average retiree under this indexation system would receive a fixed initial replacement rate at retirement. Thereafter, real benefits would be held constant. However, retirees would not benefit from real wage increases and the net replacement rate based on post-retirement wages would decline over the retiree’s remaining lifetime.31 Other piecemeal reform options include a reform of survivor pensions aiming at reducing the cumulation of own and survivor pension rights and further increases in statutory retirement ages that lower the system dependency ratio. However, the Blüm Commission proposed to postpone the reform of survivor pensions.

• Concentrating most of retirement income provision in a large mandatory PAYG pension pillar exposes pensioners and contributors to risks. There is in particular the “political risk” that piecemeal reforms will not last, even without unanticipated changes in the demographic and/or economic environment.32 However, preserving a large mandatory PAYG pension pillar is likely to put most of the adjustment risk in the long run on contributors, because pensioners are likely to resist a further discontinuous downward adjustment of first-pillar average pension replacement rates from a level around 60 percent of average net wages.

• There are considerable inter- and intragenerational inequities associated with a large PAYG pension pillar. However, as indicated below, even far-reaching systemic reforms are likely to provide less than full relief with respect to these equity problems.

• Finally, a large PAYG pillar may entail significant distortions in labor and capital markets, and systemic reforms could accordingly reap substantial efficiency gains. On the other hand, the likely need to mobilize additional fiscal resources for systemic reforms and, in the German context, the likely need to loosen the link between contributions and pension benefits in a downsized first-pillar system would at least partly off set these efficiency gains.

230. In the following paragraphs, two broad approaches to systemic pension reform are considered: (i) partial prefunding of the first-pillar system to mitigate the adverse effects of the PAYG financing mechanism; and (ii) shifting all, or part of, retirement income provision to funded private pension schemes (“privatization of social security”).

231. Partial prefunding of the first-pillar system (as practiced, e.g., in the United States) would convert the period-by-period PAYG budget constraint (1) into an intertemporal budget constraint. Under this approach, given long-term pension spending projections, contribution and budget transfer rates would be set at a level that would ensure long-term intertemporal balance of the public pension system. In view of the pattern of projected population aging, this approach would first lead to the build up of a reserve fund, which could later be drawn down as pension spending exceeds revenues under constant contribution and budget transfer rates.

232. Using the baseline staff projections of pension expenditure reported in Table V-1 (but extended to the time period 1995-2050), partial prefunding of the WSEF fund would require the “sustainable contribution rate” to be set at 25¼ percent (Chart V-6), i.e. about 5 percentage points above the current rate.33 The sustainable contribution rate can be lowered by combining partial prefunding with piecemeal reductions in pension benefits. The main advantage of partial prefunding lies in some reduction of political risk and the smoothing of contribution rates over time, the latter providing some scope to mitigate the incidence of intergenerational inequity.34 In addition, partial prefunding may have the advantage of strengthening financial discipline if coupled with the publication of regular reports on the actuarial status of the reserve fund. These reports could increase awareness of the future cost implications of current pension benefit promises, and the increased transparency could lead to more informed decisions by voters.

CHART V-6
CHART V-6

Germany Partial Prefunding of Public Pension System

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A005

Source: Staff estimates.1/ The equilibrium contribution rate is the contribution rate that maintains year-by-year balance of the pension system.2/ The sustainable contribution rate is defined as the constant contribution rate that equalizes the net asset position in 2050 with initial net assets.

233. However, in the context of a pension system dominated by a PAYG scheme, partial prefunding is unlikely to resolve all the problems outlined above. At the same time, the accumulation of a large publicly-managed pension fund necessitated by the size of the PAYG scheme raises new difficult issues. One such issue concerns the proper financial management of the accumulated assets by public sector agencies including the choice between investment in government securities and equities—both domestic and foreign—and the role of pension fund managers in corporate governance. In the German context, and again using the staff baseline projection of the equilibrium contribution rate, the accumulated reserve fund would peak at close to 60 percent of GDP around 2025 (Chart V-6). While these results are sensitive to the assumed rate of return—higher rates of return would lower the reserve accumulation requirements—and to the equilibrium contribution rate, a reserve funding would involve a sizeable accumulation of assets in the public sector. The size of the reserve fund needed to smooth contribution rates across cohorts could, however, be scaled back by additional piecemeal reform measures and/or a partial shift of retirement income provision to a funded private pension scheme.

234. Shifting a significant portion of retirement income provision to a private funded pension scheme could mitigate considerably the risk, intragenerational equity, and labor and financial market distortion problems outlined above.35 At the same time, such a shift—depending on the details of the transition—could aggravate intergenerational equity problems, induce new labor market distortions as the link between benefits and contribution in a downsized PAYG pillar is likely to be loosened, and, finally, impose a large fiscal burden. Intergenerational equity problems could be aggravated if most of the fiscal burden of the transition is imposed on the cohorts that work during the transition period as these cohorts would bear the double burden of financing pension payments to the already retired cohorts and the build-up of their own funded pension pillar. Calculations for Germany under the extreme assumptions of a complete shift to a fully funded system and no use of public debt to finance the transition indicate that non-pension expenditure would need to be cut and/or revenue would need to be increased by a total of some 3 percentage points of GDP during the transition period 1995-2050.36 Although the fiscal transition cost would be lower if only part of retirement income is shifted to a funded scheme, the fiscal transition cost would remain sizeable. Also, if public debt is used to spread part of the transition financing burden across different generations, difficulties could arise in the context of limits based on fiscal deficits and public debt. A downsized PAYG pillar is also likely to be more redistributive because it would need to fulfill the function of basic retirement provision. Indeed, in countries with smaller PAYG pillar scheme, the public pension pillar generally has a significant redistributive component. Finally, private funded pension schemes raise difficult regulatory issues regarding the government’s role in insuring pension provision including the range of powers granted to oversight agencies and the levying of insurance premia commensurate with risk.37

1

Prepared by Albert Jaeger.

2

A survey of the institutional structure of Germany’s pension system is provided by Monika Queisser, Pensions in Germany, Policy Research Working Paper No. 1664 (Washington: The World Bank, 1996).

3

The roots of Germany’s public pension scheme stretch back to the invalidity and old-age insurance law of 1889, which established the first modern public pension scheme in industrial countries.

4

Pensions for civil servants are financed from the territorial authorities’ budgets. A recent government report on the future development of the cost of civil service pensions (Versorgungsbericht 1996) suggested that total spending on civil service pensions would rise from 1.9 percent of GDP in 1996 to 2.1 percent of GDP in 2008, but then remain around the 2 percent of GDP until about 2030, and decline afterwards to 1.6 percent of GDP by 2040. The authorities’ projections for civil service pension cost are below the staffs previous projection (by about ½ percent of GDP in 2010 and afterwards) reported in SM/96/227, mainly on account of different assumptions regarding the effect of changes in early retirement rules for civil servants after 2002.

5

equation (1) ignores the WSEF’s small fluctuation reserve—which is required to amount to at least one month of pension expenditure.

6

See Association of German Pension Insurance Funds (Verband Deutscher Rentenversicherungsträger (VDR)), Versicherungsfremde Leistungen—Sachgerecht Finanzieren! (Frankfurt: VDR, 1997).

7

See Deutsche Bundesbank, “Expenditure on Social Assistance Since the Mid-Eighties,” Monthly Report April 1996, Vol. 45, No 5, pp. 33-50.

8

E.g., the flat tax rate on contributions to the separate pension funds and insurance companies was increased from 15 percent to 20 percent at the beginning of 1996. For further details on Germany’s second-pillar system see Peter Ahrend, “Pension Financial Security in Germany”, in: Securing Employer-Based Pensions: An International Perspective, edited by Bodie, Zvi, Mitchell, S. Olivia, and John A. Turner (Philadelphia: University of Pennsylvania Press, 1996), pp. 73-104.

9

See E. Philip Davis, “The Structure, Regulation and Performance of Pension Funds in Nine Industrial Countries,” World Bank Working Paper No. 1229 (Washington: World Bank, 1993). According to this source, second-pillar pension fund assets in Switzerland, the United Kingdom, and the United States exceeded 50 percent of GDP at the end of 1991.

10

The net asset holding data include financial and residential assets and cover west Germany only. See Deutsche Bundesbank, “Households’ Asset Situation in Germany,” Monthly Report October 1993, Vol. 45, No. 10, pp. 19-31.

11

Based on the “upper” and “lower variant” of the Prognos-Gutachten 1995. See Association of German Pension Fund Insurers (VDR), Prognos-Gutachten 1995 (Frankfurt: VDR, 1995). Further details of the 1992 Pension Reform Act are surveyed in SM/96/11 (pp. 12-16).

12

The Action Program established the specific target of reducing the overall social security contribution rate from 40.6 percent in 1996 to below 40 percent by the year 2000. In 1997, the overall social security contribution rate increased to 42.1 percent, and, without further reform measures, it was projected to increase to about 42.5 percent in the year 2000.

13

See Horst-Wolf Müller, “Änderungen der Finanzierung und finanzielle Auswirkungen des WFG,” Deutsche Rentenversicherung 1-2/1997, pp. 78-93.

14

The commission comprised 16 members, in the main pension experts from public pension funds, universities, and research institutes.

15

In July 1997 the Association of German Pension Insurance Funds (VDR) submitted estimates of the effects of the draft pension law proposals to the Committee for Labor and Social Affairs of the Bundestag that were broadly in line with the Commission’s estimates reported in Table V-1.

16

This proposal follows the pioneering example of earlier Swedish reform efforts to stabilize pension spending by taking account of changes in life expectancies in pension benefit adjustments (see SM/96/11 for a description of Sweden’s recent pension efforts).

17

Moreover, and also deviating from the Blüm Commission proposals, the draft pension law proposed to increase the generosity of non-contributory pension rights related to raising children. The cost of this measure would mainly come due toward the end of the projection period and would amount to about ¼ percent of GDP by 2030.

18

The Blüm Commission also proposed to overhaul provisions for survivor pensions once data from a major survey on the income situation of women become available and to strengthen incentives for occupational pension schemes and individual retirement income provision.

19

The Prognos-Gutachten 1995 was commissioned by the Association of German Pension Insurance Funds, an association of the different first-pillar pension schemes. In its publications, this association has always been strongly in favor of maintaining the basic characteristics of the present pension system. Baseline projections prepared by more independent institutions—perhaps along the lines of the regular actuary reports published by the Board of Trustees in the United States and the Government Actuary’s Department in the United Kingdom—could accordingly provide a more neutral foundation for reform proposals.

20

The World Bank’s population projections for Germany are close to the “lower variant” (i.e., pessimistic variant) of the population projection in the Prognos-Gutachten 1995.

21

The model and macroeconomic assumptions underlying the staff projection are detailed in Sheetal K. Chand and Albert Jaeger, Aging Populations and Public Pension Schemes, Occasional Paper No. 147 (Washington: International Monetary Fund, 1996).

22

The distribution of these risks between contributing and retired generations may change over time because of population aging. In particular, persons in the age group 55 years-and-above are projected to gain an absolute majority of votes in Germany after 2025, implying a significant shift in political power from the contributing population to the retired population.

23

For example, simulations of life-cycle general equilibrium models suggest that the welfare gains from public pension insurance against living longer than expected decrease significantly at pension replacement rates above 40 percent. See Victor H. Validvia, “The Insurance Role of Social Security: Theory and Lessons for Policy Reform,” IMF Working Paper No. 97/1, April 1997.

24

This intragenerational inequity bias is probably re-enforced by the comparatively lower life expectancies of lower-income earners.

25

See, e.g., the World Bank’s study (1994), Averting the Old Age Crisis (Oxford: Oxford University Press), and Laurence J. Kotlikoff (1996), “Privatizing Social Security at Home and Abroad.” American Economic Review, Papers and Proceedings, Vol. 86, No.2 pp. 368-72.

26

On the effects of pension systems of savings, see the survey paper by G. A. Mackenzie, Philip Gerson, and Alfredo Cuevas, Pension Regimes and Saving, Occasional Paper No. 151 (Washington: International Monetary Fund, 1997).

27

See, e.g., chapters 6 and 9 in Organization for Economic Co-Operation and Development (OECD), The OECD Jobs Study, Evidence and Explanations, Part II—The Adjustment Potential of the Labour Market (Paris: OECD, 1994).

28

It has been estimated that the pension benefit reductions for early retirement introduced by the 1992 Pension Act would leave average effective retirement ages by about ¾ of a year above average retirement ages under an actuarially fair benefit reduction system, necessitating to keep the contribution rate about ¾ percentage points higher than under an actuarially fair system. See Axel Börsch-Supan (1992), “Population Aging, Social Security Design, and Early Retirement,” Journal of Institutional and Theoretical Economics, 148, pp. 533-57.

29

See, e.g., the Government’s Jahreswirtschaftsbericht 1997 (1997, pp. 45-47).

30

E.g., in its 1996/97 annual report, the German Council of Economic Experts (Sacherverständigenrai) has argued in favor of shifting a significant part of retirement income provision to a funded system.

31

For example, assuming a remaining life span of 20 years and labor productivity growth of 1½ percent, the net replacement rate would decline by about 25 percentage points even though real benefits were constant.

32

For a discussion of political risks in the context of pension systems, see Peter Diamond, “Insulation of Pensions from Political Risk,” NBER Working Paper No. 4895 (Cambridge, Massachusetts: National Bureau of Economic Research, October 1994).

33

The sustainable contribution rate is calculated as the constant contribution rate over 1995-2050 that equalizes the net asset position of the WSEF in 1995 (assumed to be zero) with the net asset position in 2050.

34

Calculations of internal real rates of return for the U.S. social security system covering cohorts retiring during 1995-2030 suggest that partial prefunding can mitigate intergenerational inequities. See Eugene C. Steuerle and Jon M. Bakija, Retooling Social Security for the 21st Century: Right and Wrong Approaches to Reform (Washington: Urban Institute Press, 1994).

35

For a discussion of the issues involved in moving from a PAYG pension system to a private funded scheme, see Robert Holzmann, On the Economic Benefits and Fiscal Requirements of Moving from Unfunded to Funded Pensions, AICGS Research Report No. 4 (Washington: American Institute for Contemporary German Studies, 1997).

36

See Chand and Jaeger,”Aging Populations and Public Pension Schemes”

37

For a discussion of the experience of selected industrial countries with public insurance of private funded pension schemes, see James E. Pesando, “The Government’s Role in Insuring Pensions”, in: Securing Employer-Based Pensions: An International Perspective, edited by Bodie, Zvi, Mitchell, S. Olivia, and John A. Turner (Philadelphia: University of Pennsylvania Press, 1996), pp. 73-104.

Germany: Selected Issues
Author: International Monetary Fund
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    Industrial Countries Public Pension Expenditure As a Percent of GDP

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    Germany Demographic and System Dependency Ratios

    (In Percent)

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    Germany Intergenerational Equity Implications of Public Pension System 1/

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    Industrial Countries Public Pension Expenditure and Labor Force Participation Rates of 55-64 Year Old Persons

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    Industrial Countries Public Pension Expenditure and Stock Market Capitalisation As a Percent of GDP

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    Germany Partial Prefunding of Public Pension System