Political Determinants of Evolution and Reform of the German Public Pension Plan

lIST OF tABLES

I. History of the German public pension plan

II. Polit-economic theory of public pension schemes and pension reform
a. Voting on the financing method and the benefit level
b. A model of a representative democracy
c. Political feasibility of pension reform

III. Future reform of the public pension system – a polit-economic view
a. Problems faced today
i. Demographic developments
ii. Current issues of unemployment
iii. Implications for the development of the contribution rate
b. Suggestions made
c. Political Determinants
d. Critique

List of Illustrations

1. The median and indifference age for Germany

2. Age pyramid of the German Empire in 1875 and of Germany in 2001

3. Development of population and age quotient in Germany 2000-2050

4. Monthly development of total and long-time unemployment 2003-2004

5. Development of statutory pension insurance scheme (GRV)

6. Estimated future contribution rates

lIST OF Abbreviations

illustration not visible in this excerpt

I. History of the German Public Pension Plan

The German public pension system was the first of its kind and became a model for many social security systems all over the world. It supported the social and political stability in Germany for decades, having its roots in the “Social Insurance Laws”, passed by Otto Fürst von Bismarck in the end of the 19th century.

The “Invaliditäts- und Altersssicherungsgesetz” (disability and pension law) was the last law within the Social Laws, which came into being in 1889. At that time, average lifetime expectancy amounted to 45 years; pension was only paid for people older than 70, not including widows and orphans and without any possibility of heredity. This gave only ¼ of the population the possibility to actually receive pension. Bismarck’s funded pension consisted of two parts – a minimum pension payment and a second part, depending on the length of the contribution period. The minimum payment was not indexed to inflation and resulted in an average annual pension payment that did not exceed 18% of the average annual wage of an insured worker. Insurance itself was only open to workers whose annual income did not exceed a certain rather small amount and included workers (note: difference between workers and employees) only.

In the early 20th century a parallel compulsory pension scheme for employees was introduced. Both schemes – the workers’ and the employees’ pension schemes accumulated reserves about eight times as high as the annual expenditures. During the years of Hyperinflation in the 1920s the funded systems was confronted with a rapidly decreasing reserve which made a transformation from the Capital Reserve (CR) to a Pay-as-you-go (PAYG) system necessary. This transformation, financed through the state and supposed to be only temporarily, was able to soften the hit of the Great Depression. After World War II, restrictions and reductions of benefits could not be avoided, but the pension system recovered quickly with the “Wirtschaftswunder” and improvements of the system, such as the consolidation of the workers’ and employees’ pension scheme to one system, were introduced.

From now on the history of the German public pension scheme is a history of reforms. Not often but in frequent steps of not less than 20 years some major reforms caused

several important changes in the system.

The first reform with incredible effects on contributions and benefits took place in 1957.

During the time of Chancellor Konrad Adenauer, the average pension was at 1/3 of the average income. The adjustments in the pension system brought two major changes: firstly, the introduction of a dynamic pension that became indexed to the development of the wage level, and secondly, the radical change from a fully funded system to a fully pay-as-you-go system, introduced with and argued within the well-known “Generationenvertrag” (treaty of generations). The introduction of early retirement for women and the unemployed at the age of 60 seemed, at that time, still less hazardous. Adenauer’s understanding of the concept of the Economist Schreiber was only a partly one and this partly understanding – whether consciously or unconsciously – resulted in a fairly adaptation of Schreiber’s suggestions. Adenauer rejected the proposal of a partially funded system as well as a 3-generations-treaty, including payments for children as well as age insurance for the retired. What made Adenauer decide the way he did will be reflected more detailed in part two of this paper, where political decision-making and voting with respect to pension systems and reform will be the subjects of consideration. However, it can be said, that Adenauer’s reform resulted in an unforgettable victory on the September 15, 1957 elections, where his Christ Democratic Union won the absolute majority. The numbers, that the economy had to deal with from then on, were an instant rise in the contribution rate of up to 14% and up to a 75% level of the benefit rate.

In 1972/73 a further reform of the public pension plan took place, this time under Chancellor Willy Brandt from the Social Democratic Party. The introduction of the flexible retirement age somewhere between 62 and 67 years of age for long-term insured, the introduction of early retirement for the disabled and the unfit to work, the introduction of pension to minimum income (everybody with at least 25 years of contribution payments is treated as if he had earned at least 75% of the average income level during these years), and the implementation of the “Gesetzliche Rentenversicherung” (statutory pension insurance scheme / GRV) for all the population through the possibility of retroactive insurance showed another expansion and generosity of the government towards its people in social aspects. The expansion of the social state had its climax in these years.

Other changes were set in the late 1970s and during the 1980s, such as the reduction of early retirement age for the disabled and unfit to work from 62 to 60 years, the reduction of the necessary contribution payment period for pension at the age of 65 from 15 down to 5 years, and a step-by-step reduction of subsidy of health insurance for the retired.

Although the slogan “The pensions are secure.” was propagandised in the 1980s, it was already obvious what changes in the pension system would be necessary to face the problems to come. The reform of 1992 was the first one that finally took the necessity of reducing the social balloon of pension payments into account. Key aspects of the reform were:

- the indexing of the dynamic pension to net wage level,
- the introduction of reductions of pension payments by early retirement to 0.2% per month, and
- a step-by-step rise in the retirement age for men and women to 65 years until 2006 respectively 2012.

Additionally, the state subsidy became indexed to wage level development and contribution rates, new regularities for times of no contributions were introduced, and family concerning elements were expanded. In the years after the reform, the step-by-step rise in the retirement age was advanced to end in the year 2002 and the reductions of pension payments by early retirement rose by 0.1 percentage point. Nonetheless, the development of the contribution rate, which rose to 20% and could only be held at that level by huge governmental subsidies, still without ensuring stability in the benefit level, could not be reduced nor changed.

Under Chancellor Gerhard Schröder the reform of the pension system advanced and another reform was initiated in 1999, which eliminated the possibility of pension because of unemployment or part-time employment. It took greater account of the time for the upbringing of children, introduced another state subsidy, and stopped the introduction of a planned demographic factor, which was intended to reduce the pension adjustment in the event that post-retirement life expectancy increased. Later corrections included new regulations of the pension because of reduced ability to work and set the pension age for highly disabled to 63 years.

Two years later, in 2001, the so-called “Riester-Reform” was the first reform that did not only correct minor mistakes but tried to change the system in its roots. The PAYG-system will still dominate the public pension plan, but it will have to give up power in favour of a private CR-part. The key insight of the Riester-Reform is the governmental grant for private capital age insurance. For this, the employed should use 1% of their wage for private savings starting in 2002; this additional contribution rate will then increase every two years by one percentage point until it reaches 4% in the year 2008. Moreover, the self-responsible age securing of women was expanded, new regulations for widows and orphans were set, and a need-orientated basic pension was introduced. The goal is to secure a benefit rate that will not extend 20% until the year 2020 and 22% until the year 2030. The benefit level will be reduced, but shall not fall below 67%.

The pension reform of 2001 had adjustments in 2002, when suggestions of the “Rürup I-Commission” were taken into account. The “Rürup II-Commission” met again in 2003 and made some more specific and some more general suggestions, which will not only – if taken into account – mean more or less cosmetic corrections to the Riester-Reform but might result in another major reform in 2005.

So far this paper pointed out that the necessity of reform was not only realized, but also taken into account in the political decision making process. Nevertheless, the history of the German public pension plan is more a history of failure to reform than a history of reform. Some changes, especially in the 1950s and 1970s, were made without the necessary long-run consideration but under respect of the current social and political situation. Even worse, no action was taken in the 1980s, although the shape of things to come was already visible. In contrast, illusions like “The pensions are secure” were spread. Not until the late 1990s and starting at the beginning of the new millennium the history of the German public pension plan became a history of reform. Although within two years already two reforms took place, including some minor changes in between and after, another reform will surely come soon.

II. Polit-economic theory of public pension schemes and pension reforms

In a perfect world the government could act in favour of all the citizens and all decisions would be pareto-efficient and financially feasible. Conversely, as the history of the German public pension fund shows, decisions were made that were neither optimal nor pledging all voters ideals. This chapter tries to explain some voting behaviour and political decision making under the aspect of utility maximization on either sides – the voters’ demand side and the politicians’ supply side. For this, three models will be used. Firstly, a simple decision-making model by Verbon in 1988 is introduced to explain the voting behaviour of the individuals with respect to the financing method and the benefit level. Secondly, a model of a representative democracy by Verbon and Verhoeven will show how politicians maximize utility with respect to the public pension insurance. Finally, Uebelmesser’s voting model explaining political feasibility of pension reform will be considered to express the current situation in Germany in respect to the possibility of reform and it’s time limitation.

a) Voting on the financing method and the benefit level

The simplest and most commonly used model in literature is that of a direct democracy, where Browning’s model^[1] is not only the first one but can also be regarded as the point of reference, due to it being built on the simplest assumptions, as there are: infinite horizon of time structure, by birth-year distinguished voters, indefinite voter’s perception of the validity of the decision (the decision is binding forever), direct democracy with simple majority rule, selfish and homogenous voters, impossibility to borrow against the future, exogenous labour supply and factor prices, and possibility of private saving.

Verbon’s model^[2], based on Verbon and Van Winden (1985), does contain the essentials of Browning’s model. However, contrary to Browning, the population is now heterogeneous with respect to age but differentiated with respect to the retirement status. Thus, population at time t consists of Lt workers and Pt pensioners. As in any model of direct democracy, the age of the voter is decisive in the decision-making process; as a result the preferences of voters of median age are of only consideration. In this case, it is of importance whether the median voter is a pensioner or a worker. Considering the choice of financing method, it is assumed that the decisive worker is of age X-h, since the assumption of a retired median voter is trivial.^[3][4] A pensioner will receive swt pension for Z-X years where a worker will pay twt contributions per year with wt=gwt-1 and g being constant. Under the assumption that the premiums paid by a worker are invested with the real rate of return of r-1, then the value of the premiums paid (CT) at the retirement (time t+h) can be calculated as well as the present value of the pension payment (CP) at that time. When Verbon supposes to assume that the ratio of pensioners to workers (P/L) is constant during the rest of a person’s working life, then the preference of a voter towards a PAYG-system comes down to P/L < CP/CT . t/s . Verbon concludes that “[the] preference of the voters with median age […] depend on the structure of the population and the ratio of the real rate of interest and the rate of income growth” (Verbon, 1988). Equivalently, “the critical age” (Verbon, 1988), the age at which a person is indifferent to the two financing methods, will rise with the real rate of interest and the proportion of pensioners to the working population, thus, implementing a reduction of people favouring a PAYG system as long as the development of the population is to the detriment of the worker. The critical age is also inversely related to the rate of income growth. These results are not surprising because the introduction of a PAYG financed public pension scheme creates high gains for any pensioner or worker close to pension and thus favours a majority of the generation, especially if the age quotient is indicating an ageing society. Conversely, if the potential support ratio points out the detriment of the workers or the population is rather young, the CR system will be in favour.

Verbon’s model does also examine the decision-making on the benefit level supposing that a PAYG system is in practice. In his model a decision about the raising of the benefit level in time t has to be made. The contribution rate, related to the benefit level, equals t*= s*P/L and, thus, the value of the premium payments (CT) at time t+h and the present value of the pension payment (CP) can be calculated again for the new benefit and contribution rate level. As a result, Verbon receives that in a PAYG system “every member of the population with age X-h will favour the proposal of a higher contribution rate if DCP > DCT.” (Verbon, 1988). Hence, the decision on raising the value of the benefit rate s and, thus raising the contribution rate t in an operative PAYG financed public pension scheme is equivalent to the decision on the financing system itself. In both cases the age structure of the society is of high importance and due to the demonstrated direct relationship between the age and the preferences towards a financing method as well as the level of contributions respectively benefits, a selfish behaviour of the individuals can be assumed as reality.

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^[1] See Browning (1975)

^[2] See Verbon (1988): The Evolution of Public Pension Schemes.

^[3] X…number of years a worker has to work; h…years left until retirement

^[4] the PAYG system favours the first generation that will receive pension without having contributed at all, thus pensioners will always vote for the introduction of a PAYG system