“The safest thing about the state pension is the pension gap.” (André Kostolany)
If we compare the prospects of past and present pensioners with those of future generations of pensioners, we find that over the decades the legislator has roughly halved the provision via the German Pension Insurance Federation (DRV) in relation to the last net income before retirement.
However, even in the case of funded pensions, it can be seen that since the introduction of the ECU in 1998 and the announcement of the euro with the Stability Pact, capital market interest rates have perhaps also become minimal in the long term. If administrative costs are then higher than the long-term average return, the first life insurers are already considering whether their business model will be history in the long run. Not only have some life insurers discontinued new business in endowment and annuity insurance with the popular – but still minimal at 1.75% – guaranteed interest rates. Rather, financial investors are already standing by to unwind the life insurance portfolios as an investment for hedge funds.
Institutional investors are also taking increasingly higher risks due to the low interest rates on the capital market
Neither in the case of statutory pensions nor in the case of funded pensions can future developments be predicted with any certainty. But the risks are fundamentally different and not at all correlated. The development of statutory pensions, for example, depends on the ratio of pensioners to the working population and on the development of wages, but not on investment income – in the case of capital cover, on the other hand, the opposite is true. Therefore, anyone concerned may consider spreading the risk.
After all, there is no real “guarantee” either in the case of the statutory intergenerational contract of the DRV or in the case of funded provision (e.g. via a chamber of pensions), but rather also future influences, for example of politics and on the capital markets, which cannot be foreseen with certainty. Contact persons for individual case consultations would be, for example, experts, actuaries and pension consultants.
Institutional investors are also increasingly taking higher risks due to the low interest rates on the capital market – but rather according to the principle of hope. Because this investment behaviour changes almost nothing in terms of the statistically expected safe increase in value after offsetting the costs for the extra risk – even the annual announcement in the annual report that things went well again last year does nothing to change this. Otherwise, one would have to ask why investors have actually foregone higher return opportunities so far?
However, one cannot realistically hope for anything more than compensation for the loss of purchasing power. Blanket statements, for example that the statutory pension is more uncertain or less profitable than a pension through the pension fund, have sometimes proved to be a fallacy. Years ago, for example, a dental pension scheme had to cut its benefits by up to more than half.
Boards of trustees of other professions are also affected by the low interest rate on low-risk investments, so that their benefits may appear to be sufficiently secure only in the short and medium term. Employers who have promised their employees a company pension will have to save almost twice as much for the reinsurance of the pension funds if the market interest rate falls from 6% to 3%, for example.
Building up an additional voluntary pension of one’s own already seems obvious because, under the Retirement Income Act, the tax burden on pensions has been steadily increasing since 2005. In many cases, inflation is higher than wage growth. Professor Hans-Wolfgang Brachinger developed the “Index of Perceived Inflation” (IWI) for this purpose, with 2008 up to more than 12%. In his book “Die Reformlüge” (The Reform Lie), Albrecht Müller reports that the switch from the statutory pay-as-you-go system to a funded pension scheme has led to the greatest old-age poverty in Chile, for example.
Risk diversification can therefore be understood as not betting everything on one horse, for example not betting everything on commodities or precious metals, art and other cultural treasures, real estate or government bonds.
Every year, up to more than 40 billion euros of investment money is lost simply because investors are misled about, for example, market values, risks, functioning, costs and fees. In particular, misadvice on the part of private and state banks, whose institutional clients often include pension funds and pension chambers, became known.
The fairy tale of demographic risk
The lecture “Die instrumentalisierte Zukunftsangst” (The instrumentalized fear of the future) by Professor Dr. Gerd Bosbach, which can be found on the Internet as a video at the SWR-Teleakademie, for example, should be fundamental for understanding. It is now conceivable that the economy and the labour market will continue to flourish for decades at a low interest rate level and thus enable corresponding pension developments, whereas funded pensions will decline at least in real terms.
For example, until the 1950s the pensions of the statutory pension insurance were financed on a funded basis – which, in view of economic prosperity with corresponding wage and price developments, led to the impoverishment of social pensioners. It was only the changeover to the pay-as-you-go system that led to pensioners also being able to participate in economic development.
From the risk side, developments on the capital markets are probably subject to greater uncertainty than demographic trends, since the number of people born today and expected to enter working life in the next 25 years is already known, while the number of people entering and leaving retirement (due to death) can be projected very well on the basis of the current numbers of employed and retired people by age.
In economic terms, the issue is not so much demography as the question of how productivity progress is distributed among the various generations. The low-wage sector has been expanded from up to less than 10% to now up to more than 25%, so that correspondingly low pension contributions are paid there. This growing segment of the population has hardly any savings left, but good prospects of receiving a basic pension.
Individually, disregarding interest rates and inflation, it must be clear that it is not possible to save around 20% of one’s income for 40 working years, capped by the income threshold, and then be provided for at the same average income level for a further 20 years at 80% as a pensioner. It is realistic to set aside a third for 40 years and to live on the remaining two-thirds after taxes, in order to live on two-thirds – which are also still taxable – for another 20 years in old age.
About every 6 years, life expectancy increases by one year. Each year of longer life expectancy means that you either have to work 8 months longer to fund 4 months longer pension, or increase your saving efforts even more to fund the 12 months extra pension payment with unchanged working life. With lower pension benefits, increasing reductions in the standard of living are unavoidable. The bill would only be more favourable if the compound interest effect after costs were to clearly beat the loss of purchasing power, but this is increasingly turning out to be merely a pipe dream.
No compensation through increase in contributors to the pension scheme – unless the earnings of the younger ones are attacked
An increase in the number of working doctors due to demographic change can possibly be expected – or simply a shortage of doctors, rationing and rationalisation of health services. In favour of the latter is the fact that otherwise the contribution rates in statutory health insurance would also have to rise to more than 25%. For example, the increase in life expectancy will not lead to an analogous increase in the need for nursing care with a corresponding increase in the number of nursing staff.
Even if, however, the number of contributors to the pension scheme were to increase, the system of capital cover there is not based on the idea that young contributors finance the pensions of old people in the same way as the pay-as-you-go system, but precisely on the fact that the “self-accumulated” capital assets and the expected investment income on them serve to provide for one’s own needs. The addition of young contributors therefore does not really help to secure pensions in the pension scheme, unless there is increased subsidisation of the older by the younger. Critics are already complaining that the pensions of some pension chambers are so high that the substance of younger contributors is already under attack.
The effect and the risk of the interest rate development on the pension amounts of the pension fund are considerable.
Low interest rates, on the other hand, are having a full impact. With 4 % calculated interest, one calculates from a contribution payment that after 30 years approx. 3.2 times that amount will be available for pension payment – so almost 70 % of the pension is to be financed not from the contribution but from the hoped-for interest income. If the interest rate in reality is only just under 3 %, then only about 2.4 times the contribution is available, i.e. a quarter of the calculated amount is already missing, and at an interest rate of 2 % already about 45 % is missing. The effect and the resulting risk from the interest rate development on the pension amounts of the pension fund are therefore quite considerable.
The current low level of interest rates will probably be able to continue for decades, according to policy statements. Admittedly, politicians are responding to corresponding cries for help from life insurers and institutions for occupational retirement provision. For example, by lowering guaranteed interest rates and increasing additional provisions and solvency requirements in order to better prepare for a permanently low interest rate level.
For the pensioners, these are prospects like when the doctor prescribes a mud pack for the seriously ill and, in addition, offers to pray for him – the mud pack so that he already gets used to the smell of damp earth.
The pensions of today’s pensioners in the pension fund can hardly be financed by the capital formed for them and its earnings alone due to insufficient interest earnings and increasing life expectancy – here, reserves are often used or the investment income that was actually generated for the younger contributors. Then, however, the pensions are also to be regularly dynamised to some extent to compensate for purchasing power – but a 2 percent increase per year would require an additional 2 percent capital yield, which with an often still 4 percent actuarial interest rate means an unrealistically high full 6 percent.
This means that there is a risk of a loss of purchasing power as a result of the dynamic adjustments being left behind or not being made at all. Without dynamisation, however, the pension of a 65-year-old pensioner in the pension scheme today will lose around a third of its purchasing power by the age of 81, and half by the age of 93, assuming 2.5 percent inflation.
Members of pension schemes are therefore advised not to rely exclusively on the pension scheme alone to ensure their accustomed standard of living in old age. Even if a pension scheme performs better than other pension schemes that offer even less, this does not mean that the result is really satisfactory in the end and that drastic reductions in the standard of living in old age can be avoided entirely without additional provision.
by Dr. Johannes Fiala and Dipl.-Math. Peter A. Schramm
by courtesy of
http://www.kaden-verlag.de (Issue 2, 2014)
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About the author
Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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