A] Prelude*
* For more general and detailed information about German and EU retirement plans and systems, feel free to visit our dedicated webpages:
https://expatpensionholland.nl/germany-expat-pensions
https://expatpensionholland.nl/europe-expat-pensions
https://expatpensionholland.nl/global-pillars-systems
Ageing populations in the European Union and the pressure they are putting on pension systems funding are leading a number of countries to look at reform. The Netherlands is implementing a major reform, while France already passed a substantial reform in 2023 and remains focused on additional much needed reform.
Germany’s government is also moving forward with a reform package, though this is being held up by understandable budgetary tensions.
B] German system
The German public pension system is an earnings-related pay-as-you-go (PAYG) system. The same as in many other European countries. Which means that the contributions of current workers finance the incomes of current pensioners.
The German system is large but the challenges it faces are common to all PAYG systems:
• The ratio of the elderly (aged 65+) to the working-age population (20-64) in Germany is projected to increase from 37.3% in 2022 to 49.8% in 2050!
• In other words, by 2050 there will be almost one pensioner for each two workers in Germany and the ratio is projected to rise even further after that.
• The current net pension level of 48% of the average gross wage in Germany (for an illustrative standard career) is projected to fall gradually to 44.9% by 2040.
The latter because of a ‘sustainability factor’ introduced into the German system in a previous reform. Which limits the pension level if the number of pensioners grows faster than the number of contributors.
Thus the sustainability factor is very relevant as it links the pension level to demographics in an effort to ensure financial sustainability of the system.
C] German reform package
But the new reform package would guarantee to keep the level at 48% until 2039.
This minimum pension level in the reform package works against the sustainability factor. Instead, contributions will be increased, putting more of the burden on labor and on younger generations. The burden will however be offset to some degree by a new investment fund, to be managed by a public foundation and endowed by the government with an initial €12 billion in 2024, financed by government debt.
Thereafter the public contribution to the fund would increase by 3% each year. The government also plans to transfer an additional €15 billion of other assets to the fund in the period up to 2028. The expected value of the fund will be over €200 billion in the mid-2030s.
As of 2036 the fund would disburse €10 billion annually on average to help finance pension expenditure and soften the rising contribution rate. The contribution rate would rise from 18.6% of gross salaries currently to 22.3% in 2045 with the fund or to 22.7% without the fund.
D] Exactly what type of reform?
The proposed investment fund was hailed as a “paradigm shift” by German finance minister Christian Linder when he proposed it in March. But it is not a capitalized pension pillar. Rather it would be funded by government debt instead of pension contributions….
Furthermore the governance structure of the fund, which will be crucial to its success, remains totally unclear. It must ensure that the proceeds of the fund are only used for pensions and that the fund is shielded from any political interference. (A political movement we have seen often in similar cases.)
Furthermore the fund is projected to offset increases in contribution rates by only a very small margin. Discussions on these issues keep stalling the German reform.
E] Which age groups are funding reform?
Diversifying the sources of income for a large PAYG scheme faced with an ageing population is a good idea. However Germany’s proposed reform would be clearly at the cost of younger generations. That does not seem just. The burden of reform should be shared across generations, even if it is politically difficult.
The current reform proposal is far from a comprehensive shift in financing. It creates an extra-budgetary item that invests government debt. Instead the government should look into other options.
Like for example expanding coverage of the mandatory pension scheme to include all self-employed workers. Currently, it is not mandatory for most self-employed workers to participate in the system. Such a switch to mandatory participation is gaining ground in many other countries like for example The UK and Ireland and already established to a large extent in The Netherlands.
The German pension system would also benefit from more occupational pensions. A true capitalized pension pillar, even if small initially, would expose households to the potential risks and benefits of financial markets while reducing reliance on the government budget. The same holds for other primarily PAYG schemes in Europe.
F] Finally
The government should also aim to activate household savings by giving life to a tame private pensions market which has failed to take off because of high costs to participants. Other countries like for example the USA, UK and The Netherlands show that such plans are possible at a normal low cost level.
German households hold 42% of their assets in cash and deposits. Far more than in France, the Netherlands or the USA.
In the long-term, GDP must be high enough to ensure that the needs of retirees and workers can be met. Funded pensions can activate savings to finance real investment and support long-term growth to ultimately satisfy these future needs. Germany’s current reform proposal, unfortunately, would not anchor funded pensions in the system.
All in all very interesting to see how (or to what extent) Germany and its political arena will be able to upgrade their retirement system with the inclusion of non debt based funding, more available low cost private plans and mandatory occupational pension participation!