Playing Catch-Up.

Germany is taking its first tentative steps toward expanding private pensions to take pressure off a strained, state-run system.

Germany's pay-as-you-go pension system was to be augmented by a state-subsidized pension system by the end of this year, but the move has been delayed until 2002.

The upper house of the German Parliament, the Bundesrat, met in mid-May and approved landmark changes in Germany's national pension system. As a result, the government will sponsor private old-age savings. This move complements another piece of pension legislation already approved by lawmakers that will lower the pension level for new retirees who paid into the national system to about 67% of their last net income in 2030--from the current 70%.

German citizens are eagerly awaiting this change. Pay-as-you-go pension systems in Europe are being blamed in advance for a potential financial crisis that some industry experts believe will be brought on by the behavior of special-interest groups and politicians.

Insurers are well-positioned and could emerge as winners during this tumultuous time of change.

"It is likely that insurance companies will get a considerable amount of the new private pensions business, because it is in their natural capacity. However, banks and mutual funds will also get their share of the market," said Peter Schwark, director of the economic department at the German Insurance Association.

A Growing Need

Professor Herwig Birg at the University of Bielefeld estimates the number of 80-year-olds in Germany will triple by 2050, and the number of centenarians will rise by seven times over the same period. As a result, Germans feel a need for pension reform in their country. "Germany is way behind when it comes to pension reform," said Professor Axel Borsch-Supan, an economist at the University of Mannheim.

Speaking at a Royal Economic Society/Center for Economic Policy Research meeting earlier this year, Borsch-Supan discussed the reasons behind the increasing perceived and real difficulties of the German pension system. In a report published in the February 2000 issue of the Economic Journal, Borsch-Supan argued: "The system may be able to limp through the coming decades in its present form, but it will cease to be the exemplary Bismarckian machine. Current policy proposals are insufficient; instead, a few but incisive design changes and some degree of 'pre-funding' would rescue the present system's many positive aspects."

He further argued that a decisive step toward pre-funding could exploit the large differences in rates of return between pay-as-you-go and a fully funded system. Since the German system has far fewer redistributive features than other systems, a relatively large share of it is actual insurance, albeit at fairly low rates of return, and can thus be privatized.

But there are reasons to be conservative in the degree of pre-funding. Pay-as-you-go systems have built-in insurance against inflation and secular capital-market failures. Since Germany has experienced the disastrous effects of hyperinflation and stock-market crashes in dramatic ways, Germans probably are willing to pay a high price for this insurance.

Tackling the Tax Rules

The German government is still under increasing pressure to take the new legislation one step further by simplifying and harmonizing its convoluted tax rules for company pension schemes. Allianz Lebensversicherung, the life insurance provider majority-owned by Germany's biggest insurer, Allianz, is leading the push.

Under the proposed legislation, employees are to set aside 1% of their gross pay as of 2002, with that figure to increase in steps of 1% every two years until it reaches 4% by 2008. (According to Goldman Sachs' Strategic Management Group, savings under this plan are expected to reach $240 billion of assets in 10 years.)

Allianz, however, wants to prevent the new law from excluding one of Germany's four company pension schemes--which is built on life insurance products--from planned tax breaks. "There are presently no pension funds in Germany and thus life insurance is quite popular and is attractive because of the tax benefit sit offers," Borsch-Supan said.

In Germany, there are presently four schemes to deliver company-based pensions. They are tightly regulated and typically allow limited choice in investment and funding. As a result, less than 4% of Germany's old-age provisions stem from such schemes.

Pension Funds

The government's reform package introduces a new model for company pensions, called pension funds, which are supposed to receive the same tax and cash privileges as those earmarked for private pensions. But the investment and banking industries have complained that the government's so-called pension funds are misleading, because they do not have much in common with schemes in other countries. Instead, according to those industries, they are more like collective life insurance contracts. The insurance industry's complaint, as voiced by Allianz, is that the government intends to grant tax breaks to only one other company pension model--the Pensionskassen, which are companies structured as mutual assurance associations.

The tax break will come in the form of deferred taxation--savers will be allowed to put money away from income earned now, without paying tax until they use it at retirement. The insurance industry wants tax deferral extended to direct-insurance schemes. Under direct insurance, the employer takes out a life insurance policy on the life of the employee and vests all deriving benefits in the employee. However, in an effort to keep costs down, the government is reluctant to offer the same tax breaks for all company pension schemes.

Different Regulators

An added problem for the change in German pensions is that there are several different regulatory agencies for the many financially related activities. The Versicherungswesen is the federal regulatory agency for insurance, the Kreditwesen regulates securities. Supplementary pension funds remain one of the major financial institutions to be exclusively regulated at the national level. As a result of this separation of regulation, the industry is starting to see mergers between companies that can offer cross-regulated services to their clients.

While the European Union has devised shared rules for other areas of financial services, such as the supervision of banks, insurance companies and investment funds, in the field of supplementary pensions, the eccentricities of national regulations go unchallenged. Those national rules have imposed all manner of investment and management obligations on private pension funds to invest outside of Germany.

Sometimes, those obligations have been imposed in the name of prudential supervision. The pension funds have, for example, been required to maintain certain proportions of investments in safe but poorly performing debt as opposed to equity. Pension funds have been a captive market for government bonds, one commission official said.

Wendy Schatzman is a Brussels-based correspondent.