«Privatized pensions and economic crises. The German case. Introduction The financial and economic crises since 2000 can be seen as a sequence of ...»
Freie Universität Berlin
Privatized pensions and economic crises. The German case.
The financial and economic crises since 2000 can be seen as a sequence of
implicit stress tests and thus offer a chance to examine how the private "pillar"
of pension provisioning performed in the framework of overall pension
systems. How did private pension providers and pension recipients fare
during the crises? How did the crises affect investment strategies? To what extent can private providers cushion pension recipients against the volatility of financial markets?
Given the heterogeneity of nation states, their pension systems, and their responses to the crises, there are limits to answering these questions in a general and nonetheless informative way. Although there seem to be common trends and drifts in the major rich countries, it is not too helpful to resort to reporting averages, say, of pension fund losses (OECD 2011, 2012), if pension funds play only a marginal role in some countries and are the major source of retirement incomes in others. Thus, what follows is a preliminary case study, the case being pension reforms in Germany in the crisis decade from 2001-2011.
Before describing and discussing the German case, some features of the chain of crises since 2000 and their impact on pension systems need to be sketched as a broad background. First came the "dot.com" crisis. In the framework of "Rhenanian" capitalism, it induced the withdrawal of a lot of investments in equities just after engagement in stock markets had become fashionable. Second, the "subprime" crisis destroyed the myth, propagated by financial market makers, that investing in derivatives would safely diversify -and provide returns according to -- risks. Third, the subprime crisis transmogrified into a general economic crisis, with sharp declines in aggregate demand, investments, and increases in unemployment in the rich OECD world. Fourth, the sovereign debt crisis, which broke out not least because governments had just bailed out major corporate financial players, provided the practical proof that even government debt titles with their supposedly "riskfree" interest rates are vulnerable to default, as public debt exploded.
The chain of crises presently continues as the Eurocrisis on the one hand and as stagnation or recession in most rich OECD countries, especially the UK and US, with their economies overly dependent on financial sectors. In the course of these crises, pension systems, whether public, privatized, mandatory or voluntary, were severely damaged, but certainly not in a uniform way.
Public pay-as-you-go (PAYG) pension systems, in which the bulk of current pensions are paid from contributions or pay-roll taxes paid by the currently economically active, were mostly affected by the standard features of recessions, provoking the standard reaction of deficit spending. As economic activity declined and unemployment increased, contributions to mandatory public pension systems shrank while unemployment and unemploymentinduced early retirement caused additional expenditures. If fiscal deficits are not balanced by surpluses once growth resumes, long-term fiscal problems result -- on top of the problems connected to ageing, that is the adverse development of the number of pensioners in relation to the number of the economically active (the age dependency ratio). As the sovereign debt crisis made clear, governments cannot borrow in a sustainable way once doubts about their ability to service their debt become too serious and widespread.
Political reactions to such a situation normally include cuts in public pensions.
As the current austerity policies in the Euro-"problem countries" (Greece, Ireland, Portugal, Spain, Italy, the GIPSIs) clearly demonstrate, public PAYG pension systems are not immune to crisis1.
Whether such austerity policies are unavoidable as the means to recover from the sovereign debt crisis is another question. Thus far, they do not seem to be helpful for the return to a normal growth path.
By contrast, private pension systems, in which pension liabilities are backed by pension assets, that is investments in equity, bonds, real estate, derivatives, etc.2, were exposed to the turmoils in financial markets, first, the dotcom-, then the subprime crisis, finally, to the extent that their assets are government bonds, to the sovereign debt crisis. At the highpoint of the financial crisis in 2008, "pension funds across the OECD suffered a negative 10.5% real rate of return... Even when measured over the whole decade 2001-10, performance was a paltry 0.1% yearly on average." (OECD 2012:203) The current or prospective retirement incomes of pensioners suffered accordingly.
Most gravely affected were those close to retirement who were enrolled in "defined contribution" (DC) pension plans. Their savings had been invested, the investments were devalued and there was no time to recuperate at least some of the losses. For example, in the US the losses in 2008 of the over 45 years age group ranged from 18 to 25% of accumulated retirement wealth (OECD 2009: 26). Whereas in defined contribution plans the risks as to the size of the benefits after retirement are borne by pensioners, "defined benefit" (DB) pension schemes, in which the sponsors take the primary risk to deliver the pension according to plan, suffered from funding levels that fell far below the obligatory 100% and have not yet recovered in many cases.4 Underfunding mostly5 had no immediate effects on pensions, but will require benefit cuts if it continues. The crisis enforced the trend of discontinuing DB schemes.
Clearly, funded pension systems ran into more serious problems during the crises than PAYG systems. A stock market crash or deteriorating bond values depress the value of the capital stock that has been built up to generate the income stream flowing to contributors after retirement. In 2011, "pension fund
For an overview of the portfolio compostion of pension funds in the OECD, see OECD 2011:
The OECD revised estimates of the impact of crisis published a year before: "In 2008, OECD pension funds experienced on average a negative return of 22.5% in real terms" (OECD 2011:182) Coverage ratios, that is plan assets over plan liabilities, dropped from 102 (UK) and 104% (US) in 2007 to 76 and 82% in 2009, with the UK ratio improving to 89% and the US ratio remaining at 78% in 2011 (Ramaswamy 2012: 12) Benefits were cut in Iceland and Denmark (OECD 2012: 20) assets in most OECD countries ha(d) not climbed back above the level managed at the end of 2007." (OECD 2011: 182) By contrast, a PAYG system, while certainly also dependent on the general development of the economy, is less exposed to short run changes. Rather, the system can function as an "automatic stabilizer" of demand, either because public pension reserve funds can be tapped or because even supply-side oriented governments switch to "emergency Keynesianism" in times of recession, implying deficit spending.
In Germany, a major policy shift towards strengthening the private pillar of the pension system and reducing the role of the public PAYG system was initiated a short time before the chain of crises started.
In what follows I want to show why and how the government subsidized "private pillar" of the German pension system, effectively installed in 2002, is failing to perform. From an international perspective, the German case can be seen as a large-scale social policy experiment providing a lesson on how not to "reform" pension systems.
German pension reforms 2001ff.
Massive lobbying by the financial sector preceded the reform. In 1997, for example, Deutsche Bank established a research institute, DIA, to support the move to privatized pensions with the requisite expert research and knowledge, including the tracking of changes in public opinion on pension systems. Campaigns in the media presented the public PAYG system as more or less bankrupt6 and led to the marginalization of those pension experts, politicians or social scientists who defended the established system.
Arguments for a general introduction of three-pillar pension systems, as advocated by the World Bank and the OECD were weak (see below) and have been known as weak, most clearly since Orszag/Stiglitz (1999) and Barr Despite the long known simple fact that a public PAYG system cannot go bankrupt as long as the government maintains and uses its power to tax (Feldstein 1975).
(2000)7. Nonetheless, current advocates of funded schemes are still relying on presenting demographic changes as imminent catastrophies and the builtup of private pension systems as an adequate response (OECD 2012, Bräuninger 2009, 2011), as did the World Bank in 1994.
The so-called "Riester8"-reform of 2001 was conceived in line with the World Bank strategy of "averting the old age crisis": The mix of retirement income should be changed, in Germany by reducing the role of the dominant public PAYG system and strengthening the role of private providers, either in the form of occupational pension schemes offered by employers (the "seond pillar") or in the form of individual insurance, saving or pension fund contracts offered by the financial sector. The reform aimed for a state-sponsored construction of such a "third pillar" by providing subsidies and tax breaks to induce people to buy into pension plans on the one hand and applying pressure by reducing the pensions obtainable from the PAYG system in terms of expected rates of wage replacement. The declared aims of the reform were, first, to make the pension system as a whole demography-proof by using the supposed advantage of capital funded schemes to "prefund" pension liabilities; second, to strengthen the competitiveness of German companies by reducing gross wage costs via lowering the employers´ mandatory share of pension contributions; and, third, to foster growth by inducing extra savings that could be used for extra investments.
If we take into account the economic background in Germany at the time, it is perhaps easier to understand why aims that had little to do with pensions as such were so important for pushing through the reform. Partly due to the huge economic burden of integrating East Germany, the German economy was on a low-growth-high-unemployment path, with deteriorating real wages and a trend of a declining wage share in national income. Social security contributions (instead of general tax revenues) had been (ab)used to finance much of that burden. By transfering social security contributions from West German payers to East German receivers, the system delivered less benefits For German contributions before the reform that questioned the necessity of a switch to private funded pension schemes as a response to ageing cf. Krupp 1997, Schmähl 1999, Ganssmann 2000.
Riester was the minister for work and social policy in the Red-Green government, with a career background in IGMetall, the metal workers´ union.
at higher costs for the former, which partly explains the resonance for the propaganda about the imminent break-down of the PAYG-system.
What were the main ingredients of the reform?
PAYG contribution rates, jointly paid by employees and employers (50% each), were to be stabilized at 20% of gross wages/salaries, and to move up to a maximum of 22% when the age dependency ratio would reach its peak.
In steps over a 10-year period, the wage replacement rate was to be reduced by the so-called "Riester factor", calculated to match the public pension loss with the gains expected by participation in voluntary private pension schemes.
Contributions to such schemes were expected to amount 4% of gross wages.
To encourage such voluntary extra9 saving, subsidies and tax breaks were to be matched to contributions: full benefits for 4%, less for less10. A "sustainability factor" was also introduced into the pension formula.11 Both factors plus a new mode of using gross instead of net wages as the starting point of pension calculation work to decelerate public pension growth relative to wages, so that the wage replacement rate is declining. The "Eckrentner"pension, that a person working for 45 years for average earnings will receive, is supposed to sink to a 52% replacement rate until 2030 according to the law passed in 2004 (Schmähl 2011: 411). In terms of wage replacement for low incomes, the German system is currently already one of the stingiest in the OECD, with a rate of 52% for workers earning half the average income and contributing for 45 years (OECD 2009: 39; rates are lower only in Japan, Mexico and the US).
In higher income households, the savings rate is usually higher, so that the Riester scheme supports saving that would have taken place anyway in high income households. In addition, the tax break can be much more valuable for them than the support for An interesting asymmetry is involved here: Whereas every pensioner has to face the reductions in the PAYG-pensions introduced to alleviate financing the private pillar, only those who voluntarily participate in Riester schemes can receive the corresponding subsidies and tax breaks.
For a brief and clear presentation of the technical details of the current public German pension system, see European Commission (2009: 96-103 and 46-52 in the Annex).
Effects of the reforms
Social inequality In a social policy perspective, the effects of the reforms are worse than disappointing. The participation among persons and households with lower incomes, who would most need additional retirement incomes because they can only expect low public pensions, is considerably lower than in the upper income brackets. Frommert/Himmelreicher (2012) have analyzed the income composition of persons entering retirement in 2003 and 2007, and found that the shares receiving private pensions declines in line with total income. In terms of income quintiles, the top quintile share of households with Riester contracts is 51.3%, whereas the share shrinks to 26.2% in the second lowest and to 24.8% in the lowest quintile (Coppola/Gasche as quoted in Blank 2011:419). According to Geyer (2011), using SOEP data, participation in Riester schemes varies positively with level of education, household and personal income and number of children (there are considerable additional government benefits for households with children linked to Riester schemes).
The following explanations are offered for the unequal participation in Riester schemes when people are grouped according to income and levels of