The pension plans of the grand coalition in 2018 referring to the demographic change

Table of content

1. Table of Figures

2. Introduction

3. The German Pension system and the inter-generation compact in a nutshell
3.1. The development of the German Pension system
3.2. The inter-generation compact
3.3. Comparison between capital-covered and shared-financed systems

4. Pension plans of the Grand Coalition

5. The demographic change: development of the population in Germany and its consequences for the pension system

6. Financing of the pension plans

7. Conclusion and discussion

8. Bibliography

1. Table of Figures

Figure 1: The misery of the demographic change

Figure 2: The current pension value between 1992 and 2018

Figure 3: Development of the age structure in Germany in million people

Figure 4: Development of the federal expenditures for the general pension fund

2. Introduction

A rising life expectancy, the obsolescence of society and low birth rates - the current demographic change is a tremendous challenge for the German pension system. In its history, the German pension system has undergone several fundamental changes. Founded in 1899 as the first pension system worldwide, it continuously adapted to changing circumstances.

In 2018, the commission “Verlässlicher Generationenvertrag” is founded by the Great Coalition. Secretary of Labor, Hubertus Heil, chairs this commission. In cooperation with the Federation of Trade Unions, employers’ associations and the Max Planck Institute, the commission works out a plan to ensure the continuation of the current pension system and thus the continuance of the inter-generation compact.

This research paper focusses on how the decisions of the great coalition regarding the pension system suit the demographic change (Figure 1) and its impact on the inter-generation compact. After a short resume of the development of the German pension system and a differentiation between capital-covered and shared-financed pension schemes, the pension plans of the great coalition are analysed and evaluated from the aspect of the demographic change and their financing, before the answer to the starting question is given in the conclusion.

At this point, it has to be mentioned, that this research paper is to be understood as a general overview of the subject of demographic change, political decisions and the inter-generation compact. It explicitly focusses on the regular retirement pension and only briefly touches other pension forms like the mothers’ pension or the limited incapacity benefit whilst still using the costs of these for calculations. Therefore, the consulting of specialized literature is advised. Besides this, a basic knowledge of the German pension system is required.

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Figure 1: The misery of the demographic change, comparison between life expectancy, retirement age and birth rate (source: own)

3. The German Pension system and the inter-generation compact in a nutshell

The following chapter gives a short resume of the development of the German pension system with the aim to give the reader a better understanding of today’s regulations and decisions. Whereas the first sub-chapter treats the development of the pension system from its very early beginning, the second and third sub-chapter explicitly concentrate on the introduction of the inter-generation compact and the effects of the change from a capital covered to a shared-financed system.

3.1. The development of the German Pension system

The German pension system was founded in 1889 to alleviate the consequences of age-poverty and invalidity. While there was still an emperor ruling Germany, the Social Security was self-administrated, which means that workers, contributors, and companies were mutually responsible for its administration. Today, this is still the case.

In the very early beginning, there was no pension system as it is known today, but rather a pension insurance, which was the base for a capital covered system: employees and employers paid mutually a premium of in average 2% of the employee’s wage. If having paid the premium for thirty years in total, the employees would receive a pension on completion of their seventieth year for the rest of their life. Yet, the pension level of in average around 23% was enormously lower as it is today.

The hyperinflation which resulted from the First World War destroyed approximately 90% of the reserve funds of the pension insurance and thus, it had no more financial meanings to fulfil the demands of its insureds. This was the beginning of the partial reserve pay-as-you-go pension system and thus the first step towards a shared financing. By using the incoming payments from current contributors for the payment of the pensions, the pension scheme was capable to overcome its financial deficit.

It was in 1957, when a new formula for the system of the pension payments was introduced and the systems objective of the pension system shifted from alleviating age-poverty to replacing wages (Schmähl). The pension no longer depended on the height of the paid contribution but on the development of the wage level, the durance of having paid into the insurance and the relation of the earned average gross wage in comparison to the average gross wage of all insureds. Because of this change of the calculation, pensions increased in average by 65% to 72% and therefore the contribution rate had to be raised from 11% to 14%. Furthermore, the shared financing system with reserve funds lasting for three months only was introduced. From then on, pensions have been paid almost exclusively from the premium of contributors. This change of the system will be treated more explicitly in the following sub-chapter.

The shared financing system also played a significant role for the reunion of Germany in 1990. Because of the system, it was not a major problem to pay the pension for about four million additional pensioners from East-Germany. Furthermore, the pension payments for pensioners in East-Germany could be easily converted into deutschmark and in the early 1990’s, the current pension value could be increased twice by more than 15% (Figure 2). Yet, the shared financing system was already heavily criticized, in a time when people were aware of the future repercussions of the demographic change, because it was regarded as the present financially burdening the future (Neumann).

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Figure 2: Development of the current pension value between 1992 and 2018 (source: own), currency exchange rate: 1 DEM = 0,511292 EUR

In 2001, a first reform of the pension system was decided: the “Riester-Reform”. Leading to a “paradigm shift” (Schmähl) in the German pension system, it is characterized as one of the most important pension-reforms. The objective of the “Riester-Reform” included the stability of the contribution rate, the decoupling of the pension level and the wage level and the partly replacement of the shared-financing by a fully-funded financing. Thus, the company as well as the private pension scheme were no longer meant to replenish the general pension scheme, but to compensate its planned reduction (Schmähl). Particularly, between the years 2003 and 2008 it can be observed, that there was no increase of the current pension level. This was the case because of the Agenda 2010 and the resulting about-face towards a cost-cutting policy. Furthermore, it was decided that the retirement age will be increased to 67 years in yearly steps until 2029.

The next coalitions did not remarkably change the decisions of the 2001 reform, until the great coalition in 2014 made another face-about in the development of the German pension system, away from the cost-cutting policy. The three main decisions were a growth of the limited incapacity benefit, the increase for time spent bringing up children born before 1992 to two earning points (“mothers’ pension”) and the reduction free retirement at the age of 63. Even though the retirement age for the reduction free retirement will be lifted to 65 years, the costs of the three above described changes are tremendous.

3.2. The inter-generation compact

The inter-generation compact was unofficially created when the shared-financed system was introduced in 1957. From now on, every generation paid the pension for the prior generation and would receive its pension from the following one. By introducing the shared-financed pension scheme, children were exploited by the government as an insurance against poverty of pensioners. The consequence of this instrumentalization was, that the entire society benefits from the abundance of children and not only their own parents. This created a forced solidarity and an equal distribution of human resources as well as a rejection from the individual pension scheme (Werding). On the other hand, people who spent their time raising their children are deprived from this system, as this time “off-duty” will lead to a smaller pension by reducing the average salary earned.

However, it must be remarked that the inter-generation compact is not an official treaty but rather a symbol for the solidarity principle.

3.3. Comparison between capital-covered and shared-financed systems

After 1957, there was a quick-tempered discussion about the question whether a capital-covered or a shared-financed system was more suiting for the needs of the pension funds. Generally said, both system can be measured according to their yield. In the case of the capital-covered system the market yield is taken to measure its profit, in the case of the shared-financed system the combined result of the growth of the overall number of contributors and the growth of their contributory income is calculated. Assuming the case, that the yields of both systems are equal, there are no fundamental differences between the systems or advantages of one compared to the other (WISO). However, it was experienced in the history of the German pension systems, that a shared-financed system benefits from an increased robustness during inflations.

Nevertheless, a shared financed system buries the risk of a certain carefreeness of the pensioners. Regardless the durance or height of their contribution, pensioners receive their pension until their death. This observation becomes essential, when taking the current rise of the life expectancy into account. Whereas in a capital-covered system, expenses had to be adapted to the durance of the retirement, pensioners these days can rely on stable pension payments independent from the time of drawing them. On the other hand, pensioners who pass away soon after their retirement are the losers of the principle of solidarity of a shared-financed system (Breyer).

Referring to the Riester-Reform in 2001, the share of the general pension scheme and therefore the importance of the shared-financing was reduced and complemented by the private and the company pension-scheme which both rely on the capital-covered model.

4. Pension plans of the Great Coalition

In their coalition agreement, signed on 14 March 2018, SPD, CDU and CSU agreed on pursuing the pensions plans of their last mutual coalition agreement from 2014. It is their aim to achieve a long-term stability of the system, a just distribution of pensions between the generations and a reliable protection from old-age poverty. In the following sub-chapters, two main parts of the coalition agreement, the stability of the pension level and the installation of the commission “Verlässlicher Generationenvertrag” are treated. Additional expenses because of the mothers’ pensions, the adjustments for self-employees and reduction free pension at 63 years are taken into account for later calculations, without being explicitly described at this point.

The solution for ensuring a stable pension system, is a double yield line which fixes both, the pension level and the contribution rate to the pension system and which will be in force until 2025. According to the coalition agreement, the pension level, which describes the relation of pensions to the average income, is fixed at 48% percent. At the same time, the contribution rate to the pension system of currently 18.6% is kept under 20%. Furthermore, it is added that gaps in the financing of the general pension scheme are filled with tax revenues.

To ensure the aim of a sustainable pension system, the pension commission “Verlässlicher Generationenvertrag” (reliable inter-generation compact) is installed. This commission will elaborate solutions for the challenges of a sustainable development and assurance of the legal retirement pension as well as of the company and private retirement scheme. These solutions are planned to come into force in 2025, the year in which the double yield line will expire.

However, the plans of the great coalition are already massively criticised as financing the fixing of both, the contribution rate and the pension level can only be done by using tax revenue. For this reason, many experts warn about, that in 2025, when the double yield line is going to expire and the plans of the commission “Verlässlicher Generationenvertrag” may come into force, the pension system as it exists today will no longer be fundable. This point leads to the next two chapters, where the suitability to the demographic change and the financing of the pension plans are analysed.

5. The demographic change: development of the population in Germany and its consequences for the pension system

The demographic change of a country is a slow and steady process which is essential for political and economic decisions. As a result of this, adjustments only show an effect in the long-run, which means during the next few decades (Schmidt).

Figure 3 illustrates the forecasted development of the age structure in Germany assuming a constant birth rate of 1.6 births per woman and an annual migration balance of 200,000 people. Regarding the current birth rate of 1.5 births per woman, this forecast can be characterized as rather optimistic (destatis). Because of the low birth rate, the German population shrinks during the next few decades to 76.9 million people. However, other forecasts predict an even more rapid decline to 67.6 million people with a percentage of people above 65 years of 34% (destatis).

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Figure 3: Development of the age structure in Germany in million people (source: own, data: destatis)

During the 1960’s, the time after the Second World War, a simultaneous economic recovery led to a tremendous increase of birth rates up to 2.5 births per woman. Afterwards, from 1965 to 1975, the birth rates shrank from 2.5 below 1.5 births per woman in West-Germany. This phenomenon is described as “demographic interim” (Spiegel). The consequences of this fundamental change of the demographic development can be observed today. The “baby-boom” generation from the 1960’s reaches the retirement age from roughly 2025 on. This will lead to several retirements that exceed the number of young people who start their working life at that time by far. As the demographic change cannot and, the system must be adapted. These adaptions must include the formation of large funds in order to hold out the tremendous burden of the pension system during the 2020’s and 2030’s (Schmidt). This change underlines the necessity of capital-covered pension-schemes who are capable to cushion the future burden of the general pension scheme. Financing this interim period by governmental debt would simply postpone the problem and mean an even higher burden for future generations. (Börsch-Supan). It can be assumed, that the entire financial means would not be covered by debts only but also by a cost-cutting policy which means that investments in education are cut which leads to a worse formation of students and workers and thus to a lower salary level.

The problem is aggravated by the fact, that the birth rate is not considered for the calculation of the pension. Although this factor was simply forgotten in the pension reform in 1957, there has not been a single change made until today (Bünnagel/Eckhoff). By nationalizing the abundance of children at that time, the government eliminated individual incentives of having children as an insurance against old-age poverty (Gräßler). The only factor which considers the demographic change in a certain degree is the sustainability factor which calculates the relation of contributors to pensioners. However, this factor is only one of three factors that are used to calculate the adjustment of the current pension value. Besides this, it is foreseen by law that the current pension value cannot be decreased. For this reason, pensions cannot be reduced even if there was negative population development as well as a negative economic change.

Additionally, the shared-financed system relies on both, a growth of the contributors as well as on a growth of the economy. In 1957, roughly 11% of the entire population were 65 or above. In 2018, this share has doubled to 22%. Combining this circumstance with the expanding reference period which increased from ten years in the beginning of the pension fund to 20 years in the late 2000’s, it is obvious that the system must necessarily be linked to the life expectancy to achieve a balanced relation between time-worked and time in retirement. Furthermore, the future development of the age structure has to be regarded and financial deposits have to be created for times, when there is not a sufficient number of contributors. For this reason, it is not comprehensible why the great coalition fixes the contribution rate. It is obvious that a fixed contribution rate of under 20% is not reasonable to finance a pension level of 48% when taking a decreasing number of working people and a simultaneous increase of pensioners with an expanded life expectancy into account.

6. Financing of the pension plans

The additional costs of the pension plans of the great coalition can be estimated to around nine billion Euro per year. For this reason, the sustainability fund of currently 30 billion € of the general pension fund will be used within the next three years (Börsch-Supan). However, the prior chapter shows, that funds are particularly needed from 2025 on as a result of the retirement of the “baby-boom generation”. Therefore, this chapter treats the lift of the retirement age as a possible way of how to fill the gap of the pension scheme after an analysis of the federal budget in 2017 to point out the current circumstances.

In 2017, the government paid 98.25 billion Euro (Bundeshaushalt), approximately 30% of the total of the German federal budget, to the general pension fund including the basic cover of social protection and the limited incapacity benefit. Taking these number into account, the payments to the pension funds make up for more than 70% of the total expenditures of the Federal Ministry of Labour and Social Affairs “BAMS” and are higher than the accumulated expenditures for the Ministries of Defence, Traffic and Digital Infrastructure, Education and Research and Health. During the last five years, the expenditures for the general pension fund have, in average, annually increased by 3.24% (Figure 4) whereas the total expenditures of the federal budget have increased by a slightly smaller amount of 1.44% (Bundeshaushalt).

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Figure 4: Development of the federal expenditures for the general pension fund

Taking the above-mentioned averages into account, one can determine, that the share of the expenditures of the federal expenditures for the general pension fund of the total federal expenditures has annually increased by 0.51 percentage point.

In the following part, an increase of the retirement age with the aim of decreasing the deficit of the general pension scheme, when not taking the federal subsidizes into account, will be analyzed and assessed based on its consequences for the inter-generation compact.

For a sustainable financing of the shared-financed pension scheme, it is elementary that the life expectancy and thus the durance of drawing payments from it must be linked to the time of working. Assuming the fixed contribution rate of under 20% and a pension level of 48%, one should pay their contribution, which means one must work, for 2.4 years to finance one year of their retirement. Or: 2.4 people have to work for one year to finance one year of pension payments for a pensioner. Translating this ratio to a life expectancy of currently 81.09 years for babies and a start of their working life at the age of 20, this means that the remaining 61.09 years are split into 43.12 years of working and 17.96 years of retirement. This short calculation comes to a similar result as the decision of the great coalition about the retirement without fees at the age of 63. At this point the question that needs to be asked is: Why does the retirement age need to be lifted?

This question can be answered by referring to several factors. Firstly, the life expectancy is not an accurate measure to calculate the share of work time to durance of retirement as it is an average figure. The death of infants dramatically lowers the average life expectancy. Secondly, people who die under the age of 20 cannot pay a contribution to the pension scheme. This point exposes the second problem: the shared-financing of the general pension scheme requires at least a stable development of the population, but preferably a growing one, not to mention a growing economy. As this circumstance is currently not given, the overall contribution paid is not high enough to meet the requirements of pension payments from the system on its own. To estimate a just age of retirement, which fulfils the basic need of the inter-generation compact, the following formula can be used (source: own).

A(rn) = new age at retirement, D = Durance of pension drawing, PL = pension level, CR = contribution rate, br(cp) = birth rate for constant population, br(a) = actual birth rate, A(b), age when starting work life, A(ra) = Actual age at retirement

Assuming the planned contribution rate of under 20%, it is calculated as 19.9%, the pension level is 48%, the average durance of pension withdrawing is currently 20.6 years, the birth rate needed for a constant population is 2.1, the actual birth rate is 1.5 and the age when starting a work life is estimated at 20 years (destatis). This gives the following result:

It is obvious, that the calculated age of retirement is not realistic as it is more than ten years higher than the average life expectancy. To change this, the new age of retirement must be linked to the average durance of pension withdrawing as per every year the retirement age is increased, the durance of pension withdrawing is decreased by one:

When using this modified formula with the same values and the future age of retirement of 67, the result is A(rn) = 72.83 years. This means that from a mathematically point of view, people must work almost six years longer and thus would only receive their pension for 14.77 years, although they have worked for 52.83 years.

At this point, it must be mentioned, that the above explained formula is only a sketching of the calculation of a new retirement age which supports the inter-generation compact. Many crucial factors such as the economic development, including unemployment rates, increase of salary level and economic growth, the increase of the current pension value, additional costs from mother’s pension and subsistence income are not considered. Besides this, it is doubtable that every profession can still be practised at such a high age. Furthermore, it would need decades to increase the current retirement age of 67 to 72.83 years when increasing it for one or two months per year as it is currently done.

However, it illustrates, that the planned retirement age of 67 is far away from supporting the inter-generation compact, which would be fulfilled at an age of roughly 73 years. With the purpose to keep the compact alive, the government heavily subsidises the general pension fund (Figure 4) and therefore does not have the money to invest in other ministries. This lack of investments for the younger generation means a violation of the inter-generation compact for the benefit of the older one.

To resume this chapter is must be recorded that the pension plans of the great coalition are not fundable. It is rather the delaying of a financial deficit with the objective to fulfil election promises (Boysen-Hogrefe).

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