German pension reform: first steps along a difficult path

Under pressure from accelerating population aging and previous pension-reform backsliding, Germany’s government has agreed to implement more than 30 reform proposals issued in June by a special pension commission. The measures – subject, of course, to potentially diluting changes in the Bundestag – aim to put Germany’s pension system on a financially sustainable track by introducing a number of important concepts.

The planned reform echoes measures intended to ensure pension-system stability in other European Union countries, including Denmark, Finland, Greece, the Netherlands, Portugal and Sweden. But the German move puts the vital question of pension reform on the European political map – not least for France’s next president – in a way smaller countries cannot. It could also help in deepening European capital markets as German pension savings are invested at home and across the EU and globally.

However, in comparison with EU best practices, the German plan suggests only modest reform for now. It sets a direction, but truly ensuring financial sustainability in the German pension system is left to the future.

Of the changes proposed by the pension commission, three stand out: linking of retirement ages to life expectancy, a beefed up financial ‘sustainability factor’ and a new prefunded pillar.

The life expectancy link will be introduced from 2031, when currently legislated increases in the statutory retirement age to 67 are completed. From 2032, the German retirement age will rise by eight months per one year rise in life expectancy, targeting a year of retirement for every two years spent working. This should mean that the German retirement age will rise roughly six months per decade, reaching 68 by 2051, 69 by 2071 and 70 by 2091.

This is a major change, especially as the commission has also proposed to abolish the current access to early retirement at 63 (with 45 years of contributions) and to tie future early retirement, with benefit deductions, to the life-expectancy-linked retirement age minus three years. Germany will become the tenth EU country with an explicit life-expectancy link to future retirement ages (in addition to the countries listed above, Cyprus, Estonia and Italy have such links). Other countries may pick up the signal.

However, Germany’s life-expectancy link is not particularly ambitious. In Denmark and the Netherlands, with life-expectancy projections comparable to Germany, retirement ages will rise to 70 by 2041 and 2070 respectively. As population aging in Germany is expected to exceed that of Denmark and the Netherlands, future German governments may have to revisit the life-expectancy link.

The second main reform, the upgraded ‘sustainability factor’, will dictate that from 2032 a third of the financing burden from population aging will be borne by retirees through lower pension increases, while two thirds will be financed from higher pension contributions. Shifting the financial burden to retirees makes sense in Germany, where, as in many EU countries, employers and employees already suffer from high pension contribution rates, scheduled to rise further in the future.

Yet, when compared Sweden, which has an ‘automatic balancing mechanism’, the German sustainability factor is a weak commitment to keep future pension contribution rates from rising. In Sweden, the entire burden of ensuring future sustainability of the pension system falls on the liability side, in the form of lower future pension benefits. If – as between 2010 and 2018 – the Swedish pension system is deemed out of balance, upward indexation of the gradually accruing pension rights of the working population, and of pensions themselves, can be suspended, splitting the ‘pain’ of restoring the fiscal balance between current and future retirees.

Third, Germany will introduce to its existing public pay-as-you-go pension system a prefunded pillar worth 2% in additional pension contributions, phased in from 2028-2031. These contributions will be paid into individual pension accounts for all German wage earners, who can choose between a standard public investment product or a limited set of certified investment alternatives.

This is long overdue step. By 2031, the 2% annual contributions will amount to about €35 billion, or 0.8% of German GDP. But compared to Denmark and the Netherlands, where contribution rates are typically between 10% and 18%, it is clear that the new German pillar can only be a first step in a gradual push towards a greater reliance on prefunded pensions. Additional government initiatives or social-partner agreement on higher contributions are likely to be required if this new pillar is to materially improve the financial sustainability of Germany’s pension system. In sum, an improved course for Germany’s public pension system has been set, but future German governments must walk further down this path. 

A Bruegel comparative analysis of EU pension systems is forthcoming.