Growing old in dignity

Table of Contents

1. Introduction
1.1 Bismarck’s reform of 1889
1.2 Reforms of 1957 & 1972
1.3 Riester reform of 2001
1.4 Rürup reform of 2004

2. Today’s situation of the German pension system
2.1 The first pillar pensions and old-age pension
2.2 The second pillar pensions
2.3 The third pillar pensions
2.4 Demographic Development

3. Economic Challenges
3.1 Female workforce
3.2 Immigration
3.3 Recent Changes in the Pension System
3.4 Implications to the healthcare sector

4. Pension system in developed countries
4.1 Italy
4.2 Japan
4.3 La France
4.4 Netherlands
4.5 Sweden
4.6 United Kingdom
4.7 Summary

5. ITM Checklist

6. Conclusion

List of Abbreviations

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List of Figures

Figure 1: Structure of population end of 2005 and prediction for 2050

Figure 2: Normalized place in Kindergarten for Schleswig Holstein and Denmark

Figure 3: Theoretical required increase of productivity to fill the demographic gap

Figure 4a and 4b: Pension entitlement and Pension entry value

Figure 5: People over 80 in need of care

Figure 6: People over 80 in need of care

Figure 7: Compensation options of first pillar’s replacement rate

1. Introduction

Growing old in dignity is a desire that we all have inside. Not being able to make our own living out of what we have worked for during the longest part of our life will make people feel sad and like ballast for society. This paper describes the evolution of the pension system from the very beginning, the period where high replacement rates were realized and the first pillar was a trusted installation to make people feel confident about their future and the way they will conduct their life as pensioner. Low fertility rates had made this system collapse provided that there weren’t interferences to the system as it was established until about the end of the 20th century. The greatest challenge of the 21st century has been identified as the demographic development and its impact on the balance of the pension system. Seeing the demographically induced mismatch between the number of contributors and pensioners the system was changed from a defined replacement rate system to a defined contribution system while increasing the time of contribution by extending the pension entry age. Hence, the monetary load of contributing generations was limited to finance the first pillar resulting on the other side in a modification of the replacement rate that is nowadays linked to more factors than only a simple wage development. The introduction of the before mentioned factors and the most important sustainability factor transformed this system into a quite well predictable self controlled pension system. However the outcome after predictions is a replacement rate which levels slightly above the legally fixed minimum.

Against this background, this paper explores a major concern that all German citizens face in a determined age of their life. It is fact that more and more people are getting older and, in a first moment, are dependent on the public pension system. As pension provisions paid from the public pension funds tend to decrease, consequently more and more persons will be obliged to live with a lower pension benefit. As a result they will get problems in financing their basic needs. Therefore, as mentioned in the recent media, the Federal Government of Germany plans the introduction of a statuary minimum pension for low wage earners in 2011.

1.1 Bismarck’s reform of 1889

In light of the huge industrialization occurred in the 19th century, numerous social changes took place: People moved to cities and near to industrial centres, families were getting smaller and the life expectancy increased considerably. A new working class evolved in parallel to a new life style afford due to urbanization. Based on these changes, families and local communities were facing difficulties in maintaining individuals which were not able to work anymore due to their age, accidents or illness. As a result of the mentioned developments and in order to support the forming working class, the German Chancellor Otto von Bismarck declared in 1881 the creation of a social security system. Thereupon, in 1889, Germany’s public first-pillar system, the first formal old-age social insurance system, was introduced.

When Chancellor Otto von Bismarck in 1889 introduced the statutory pension insurance scheme in Germany, the average life expectancy of newborns at that time was about 40 years, the retirement age however, was 70 years. Therefore only a minority could experience the payment of a retirement pension.

Only one quarter of men and one third of the women could hope to achieve the 70th years. Nowadays three-quarters of men and almost 90 percent of women achieve the age limit of 65 years. In comparison with that time, 65-year-old men can now enjoy their retirement for in average 16 years, and women even almost 20 years. At Bismarck’s times working life took 55 years, from primary school completion with 15 years to retirement at the age of 70. The pension insurance came with a contribution of 1.7 percent. According to GUARDIANCICH (2010), the contribution rate today is 19.9 percent, continuously growing.

Furthermore, as commented in FRERICH AND FREY (1993), together with the Accident Insurance Act of 1884 and the Health Insurance Act of 1883, the Disability and Old Age Insurance Act of 1889 {Invalidität!- und Alterversicherungsgesetd) marked the beginning of the compulsory public social insurance system. The Disability and Old Age Insurance Act introduced a mandatory insurance for blue-collar workers. Insured workers were entitled to benefits at the age of 70, after a minimum of 30 years of contributions, and they were also entitled to invalidity benefits. Many workers couldn’t profit from this scheme because life expectancy at that time was in most cases lower than 70 years.

In the so named “pay-as-you-go” (PAYGO) system, introduced by Otto von Bismarck in 1889, the compulsory contributions of workers and employers were not capitalized for their own retirements, but paid into a pension fund, out of which the benefits of current pensioners were paid. To be more precisely, each worker had an individual account in which benefit rights were accumulated. The worker’s contributions were credited to the individual account but no funds were deposited into it.

1.2 Reforms of 1957 & 1972

At the commencing of the twentieth century, in order to avoid the federal grant that was already valid for the blue-collar system (Versicherungsgesetz für Angestellte of December 20, 1911), the government established a separate insurance scheme for white-collar workers. As stated in FRERICH AND FREY (1993), the act provided contribution-financed benefits at the age of 65, after 10 years of contribution for men and 6 years for women, and also disability benefits. After World War II, blue- and white-collar employees have been administratively separated again. Once the calculation of pension benefits did not consider the inflation or wage increases, the level of benefits in the early 1950s was inadequate. Therefore, agreements on a comprehensive pension reform throughout the 1950s resulted in the pension reform of 1957, which mainly established the following major changes: the normal retirement age at 65; the retirement at the age 60 for elderly unemployed (blue-collar workers); the retirement for women at the age 60 and the introduction of dynamic benefits indexed to gross wages, which, as discussed in HINRICHS (1998), had an immediate impact on the economic wellness of current retirees, because the benefit formula and the post-retirement adjustment of benefits were made dynamic by taking into account individual, lifetime earnings in relation to average earnings of all ensured when calculating the pension amount and annually upgrading in relation to gross wage growth in order to help the retirees to participate in the economic progress. The benefit increase up to 70 percent in spring of 1957 transformed public pensions as a floor of retirement income into an actual wage replacement that went up to a higher ratio subsequently.

The last expansive and complex German pension reform took place in 1972 and represents one of the most generous of the world, basically because of the following main traits: The Reform Act opened the public pension insurance system to all citizens (usually self-employed, housewives), therefore workers who voluntarily joined the GRV (Gesetzliche Rentenversicherung) received generous terms for back-payment of contributions. Furthermore, the 1972 reform eased the terms and conditions for early retirement by the implementation of the so-called ‘flexible retirement’, with the option of retiring at 63 with full benefits for workers with a long service history. In addition, retirement at age 60 with full benefits became possible for women, the unemployed, and older disabled workers, referring to those workers who couldn’t be appropriately employed for health or labour market reasons and are age 60 or older.

1.3 Riester reform of 2001

The dominant component in the German pension system is the public pension, the main income source for the majority of German pensioners. The Statuary Pension Insurance, the so called “Gesetzliche Rentenversicherung” (GRV) is the most important public pension scheme and covers more than 80% of the working population in Germany. In order to reduce the public pension payments to participants in the GRV, an intensive work on the pension system started in February 1999, when the minister oflabour and social affairs at the time, Mr. Walter Riester (from SPD party), nominated a team of seven experts for consultations on the pension policies. The incorporation of private pensions was the most valuable and innovative component in the pension reform of 2001. Initially, according to Riester's plans presented in June 1999, the introduction of a private old age pension provision was to start in 2003. Therefore, a yearly increase of 0.5 percent of employee’s gross wage (up to the contribution ceiling) to a private pension fund would establish a permanent contribution of 2.5 percent by 2007. Following Riester's plans, the contribution to private pensions should be compulsory for all employees, but they would be free to choose the types of investments, however, this requirement has been rejected by CSU in the pre-parliamentary stage.

In May 2000, Riester's pension reform draft has incorporated the first criteria for types of investment for private pensions to be eligible to federal allowances and the spectrum of potential beneficiaries of government subsidies has been significantly extended. It was established that investment should be paid out as a life-long pension and the minimum return should to be at least equal the deposited value. Riester presented his final draft for the pension reform in September 2000, providing the following change: pension contribution rates would be kept below 22 percent until 2030 with a simultaneous replacement rate of 64 percent. The bill has been approved by the Federal Cabinet in November 2000.

The main innovation of Riester's pension reform was the establishment of a capital-funded supplementary private pension pillar that would be subsidized through tax-deductible contributions. The objective of the non-compulsory private pension, known as Riesier-Renie, was to offer incentives for individuals to take supplementary private pension to compensate future cuts in state pensions. In other words, the objective of the reform was to encourage individual’s interest in supplementary pension provisions in order to reduce public pension responsibilities to maintain financial sustainability of public finances. The occupational pensions should be strengthened in granting employees the right to convert part of their wage into pension contribution payments to occupational pension schemes (Entgeltumwandlung).

Contributions to occupational pension schemes and personal pension provisions based in a ‘Riester contract’ are deductible as special expenditure (Sonderausgaben) from the taxable income up to a certain limit (€1575 p.a. in 2007). The benefits from such occupational and personal pension schemes are subject to income taxation, i.e., taxation of ‘Riester’ supplementary pension schemes corresponds to the known EET model (which means: contributions are Exempt, investment income is Exempt during accumulation, benefits are Taxed).

1.4 Rürupreform of 2004

In November 2002, the German Chancellor Gerhard Schröder at that time, asked Professor Bert Rürup, an influential economist and long-term advisor to several German governments, to lead a commission with the objective to make further recommendations on paths of achieving financial sustainability in the social security systems. The so-called “Rürup Commission” took into consideration estimations made by a broad range of researchers and experts, which revealed that without further reforms the pension contributions would rise to over 24% by the year 2030. Once the German government has committed itself to taking action in case the contribution would increase to over 22% by the year 2030, the two major recommendations made by “Rürup Commission” were: 1) to increase the retirement age by one month per year between 2011 and 2035, from 65 to 67 years for all workers, with full effect for all insured born in 1969 or younger. In parallel, the age limits for early retirement would also be raised to maintain the overall structure of the various paths to retirement. 2) the introduction of a “sustainability factor” (Nachhaltigkeitsfaktor) by linking annual pension indexing to the changes in the ratio of pensioners to workers supporting the system. In other words, in order to ensure that future benefits can be financed, the “sustainability factor”, which strongly depends on the labour force, enables annual adjustments in pension benefits to be placed in line with the changes in the population and the labour market.

As argued in HAIN et al. (2004: 333), the sustainability factor reflects the ratio of pensioners relative to contributors adjusted to pensioners with 45 years of full contribution employment. It affects both current pensioners, although with modifications during transition period, as well as future pensioners. The sustainability factor is weighted by a certain parameter a that was fixed to 0.25 in 2004 but provides easy access for future political limitations. The assessment base of wage increases for pension indexation is reduced from all employees to real contribution base. Civil servants' wages and wages above the contribution limit are excluded.

2. Today’s situation of the German pension system

The statutory pension insurance system of today developed from a law introducing invalidity and pension insurance under Bismarck in 1889. In it’s more than 110 years history, the state pension has developed from a subsidy towards general living costs to form the main part of most people's retirement income.

Aiming to replace the old pay-as-you-go pension scheme by a new three-pillar-system, the German pension system has been submitted to a radical structural reform which was discussed since the beginning of the 1990s and implemented in 1999. All persons insured under the age of 50 onjanuary 1st 1999 fall under the coverage of the new pension rules, whereas the others will remain in the old pension system.

Nowadays the German three-pillar system, whose main idea is that security comes from diversification of sources of pensions, consists of the following elements: The first and most important pillar is universal, mandatory organized as a pay-as-you-go system. The second pillar is the voluntary occupational pension system which is also universal and mandatory, but capital funded, as well as the third pillar which is a voluntary private provision system and contains elements such as private pension plans, portfolios, real assets and private pensions that are not subsidized. The main characteristics of each one of the three-pillars will be shortly outlined in the next chapters.

2.1 The first pillar pensions and old-age pension

As discussed by CALIENDO (2009), the public retrement insurance or “first pillar” is characterized by elements of the core system, such as the old-age pension, disability pension and survivor benefits. The general pay-as-you-go earnings-related first pillar statuary pension scheme covers approximately 85% of the German work force, including workers of the public sector that are not civil servants. With minor exceptions, all employees pay compulsory contributions, comprising also trainees, disabled people employed at sheltered workshops, people on military or civilian service, and people doing a year of voluntary community or environmental service. As discussed in SCHMIDT AND TROTZEWITZ (2003), only students, people with low income (meaning earning less than 325 EUR per month or working less than 15 hours per week) and self-employed people are excluded from the first pillar.

The statuary pension insurance system basically covers the following: 1) old-age pensions, 2) reduced earning capacity pensions and 3) surviving dependants' pensions, which means the pensions on account of insured pension’s death. In this paper, only the old-age pensions will be explored based on the current on-line data-base available by the Federal Ministry ofLabour and Social Affairs.

Based on a law aiming to adjust the minimum pensionable age in line with demographic change and in order to place the statutory pension insurance systems on a solid financial footing (the Rentenversicherungs-Altersgren^enanpassungsgeset^) the minimum age for a standard pension in Germany is to be gradually increased from 65 to 67 between 2012 and 2029 and, the minimum ages for other pensions are to increase accordingly.

Furthermore, only the insured person can claim an old-age pension. Therefore, the person must have reached a set age, which is the minimum age limit. Depending on the type of pension, further conditions may also have to be fulfilled. Moreover, a person can claim an old- age pension in full or as a partial pension in the amount of one third, half or two thirds of the full pension entitlement.

An overview of the main types of old-age pension available and the respective involved ages at which they can be claimed are described in the following paragraphs. Other types of old-age pension, such as the old-age pension on account of unemployment or after partial retirement and the exceptionally long service pension will not be presented in this paper.

In a standard old-age pension, a person can claim the standard old-age pension Regelaltersrentè) when he or she reaches the minimum age provided that the person have completed the 5-year general qualifying period. The regular minimum age is 65 years for people born before 1 January 1947 and it is 67 for people born in 1964 or later. The minimum age rises in steps for people born in the years 1947 to 1963.

An insured person can claim a long service pension if they have reached the age of 67 and completed the 35-year qualifying period. The 35- year qualifying period for a long service pension or severe disability pension can additionally be made up with exempt periods and certain child-raising and care periods are also taken into account. Such exempt periods can be periods of education and training and periods of illness or unemployment. This pension can be claimed early from age 63, thus, those born before 1949 can claim an unreduced pension from age 65. For people born from 1948 to 1963, the minimum age for an unreduced pension rises in steps from 65 to 67.

The old-age pension for women {Altersrente fir Prauen) can be claimed with reductions by women born before 1952, who have reached the age of 60, completed the 15-year qualifying period and paid compulsory contributions for more than ten years since the age of 40. Therefore the pension can be claimed early from age 60. For insured persons born after 1951, the possibility of drawing a pension earlier has been completely eliminated. Another characteristic of the old-age pension for women is a reduction in pension amounting to 0.3 percent per month if the pension is paid prior to their 65th birthday.

Another old-age pension is foreseen for people with severe disabilities. In this case, insured persons can claim a severe disability pension {Altersrente für schwerbehinderte Menschen) if they have reached the age of 65, completed the 35-year qualifying period and are recognised as having at least a 50 percent degree of disability. This pension can be claimed early from the age of 62. People born before 1 January 1952 can still claim it from the age of 63 and may claim it, in some cases, from the age of 60.

2.2 The second pillar pensions

The second pillar comprises the subsidized and occupational pension scheme. Based on this, occupational pensions such as direct pension assurances, benevolent funds, retirement income insurance and pension funds are provided by companies to their workers. These occupational pensions differ regarding the taxation and possible paths of subsidies from the government.

According to BLAICH {2010), currently many changes driven broadly by the financial crisis and international accounting standards are happening in the German second pillar. The second pillar in Germany can be divided into two sub-pillars as follow: the direct pension promises and the indirect pension promises, with the last being sub-divided into pension fund societies {Pensionskasse), support funds, primary insurance and pension funds. In total, there are five ways to finance occupational pensions in Germany. Each scheme has very different functions and provides its own distinct advantages and disadvantages.

In the direct pension promises method, the employer is directly responsible for the compliance of the pension promise. The pension benefits are paid directly by the employer from the employer’s cash flow. Most companies insure their direct pension promises through an insurance company and all companies which opt for the direct pension promises must pay into the Pension Insurance Association (PSV).

Among the indirect pension promises, the pension fund societies are characterized as being out-sourced and legally independent entities, and represent the second major financing method. This method can be applied either for a single company or for an entire industry sector. The Pension fund societies, which are regulated by the German financial regulator (Bafin), takes out an insurance contract for the employee and builds up capital from which the pension is paid; therefore the employer is not required to pay into the PSV. In this case plan participants have an entitlement against the pension pool.

The Support funds, similar to the pension fund societies, are externally-funded pension schemes. However, employers must pay into the PSV as the plan participants have a pension entitlement against the corporation instead of the fund. With this method the company can pay almost unlimited amounts of contributions tax-free.

In the primary insurance, also known as direct insurance, companies close an insurance contract directly with an insurer on behalf of the employee. This method offers low administrative charges and no PSV contributions have to be paid.

At last, the pension funds (Pensionsfonds), that have been originated with the 2001 reform, are the fifth financing method and create an internationally recognized alternative to other financing methods. Pension funds represent about 3.2% of total assets.

2.3 The third pillar pensions

As discussed in HOLZMANN and HINZ (2005), the third pillar comprises voluntary and pre-funded pension plans, which could be whether occupational or personal plans, established and regulated to ensure a clear retirement objective. Depending on the form of benefits, the third pillar can also provide longevity insurance, but its provision would rely on private sector institutions (e.g. life insurance companies, banks or pension funds still with individual membership).

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