Pension indexation models and their influence in the sustainability of pension systems. The case of Germany. Madrid, 24 June 2016

Page 2 1. A brief history of the German Pension System 2. Demographic situation in Germany 3. Pension Reforms for Sustainability Reasons 4. Indexation within the German Statutory Pension System i. Pension entitlements ii. Calculating a pension iii. Indexation of pensions Outline

Page 3 A brief history of the German Pension System In 1889: Foundation of the German pension system by chancellor Bismarck disability and pension insurance within a funded system pension as additional income source Reform in 1957: Major reform established prevailing general principles income replacement in old-age within a pay-as-you-go (PAYG) system pension indexation to gross wage development

Page 4 A brief history of the German Pension System Reform in 2001: promoting 2 nd and 3 rd pension pillar promotion of tax incentives for 2 nd and 3 rd pillar introduction of “Riester pension” as part of 3nd pillar

Page 5 Demographic developments Age-distribution; German population, 2013 male female total: 80.8 mio 1955

Page 6 Demographic developments Old-age dependency ratio individuals at age individuals at age 65+

Page 7 Demographic developments Age-distribution; German population, 2060 male female total: 70.8 mio (Eurostat, 2013) 1955

Page 8 Demographic developments Old-age dependency ratio individuals at age individuals at age 65+individuals at age

Page 9 Pension Reforms for Sustainability Reasons 1992: increase statutory retirement age for old-age pension for women from age 60 to 65 in 2001 implementation of deductions for early retirement 2001: promotion of tax incentives for 2nd and 3rd pillar, introduction of “Riester pension” as part of 3nd pillar

Page 10 Pension Reforms for Sustainability Reasons 2004: introduction of sustainability factor for pension indexation, 2007: increase statutory retirement age from age 65 to 67 in : retirement at age 63 without pension penalties (increasing to age 65)

Page 11 Pension Reforms for Sustainability Reasons The German pension system today Old-age provision in Germany 1. pillar mandatory 2. pillar non- mandatory 3. pillar non- mandatory Statutory Pension System Occupational Pension Scheme Private Pension Scheme

Page 12 Pension Reforms for Sustainability Reasons Today, the German statutory pension scheme: covers about 85% of employed population, includes old-age, disability and survivors pensions, provides specific benefits for child rearing and home care of care- dependent people, Is in general an earnings related PAYG point-system, does not provide minimum pensions.

Page 13 Indexation within Statutory Pension System Pension Entitlements in the German statutory pension scheme Point system over the complete employment history A years’ contribution at the level of average earnings of contributors results in one pension point (EP)

Page 14 Indexation within Statutory Pension System Pension Entitlements in the German statutory pension scheme Point system over the complete employment history A years’ contribution at the level of average earnings of contributors results in one pension point (EP) Example with average yearly earnings in Germany 2010: 31,144 EUR Fritz has earned in 2010: 31,144 EUR1.00 EP Maria has earned in 2010: 40,487 EUR1.30 EP Example with average yearly earnings in Germany 2014: 34,514 EUR Franz has earned in 2014: 31,144 EUR0.90 EP Marlene has earned in 2014: 40,487 EUR1.17 EP

Page 15 Indexation within Statutory Pension System Calculating a monthly pension The general equation for monthly gross pensions Type Factor: reflects the different pension types, e.g.: old-age pensiontype = 1.0 widow’s and widower’s pensiontype = 0.55 Gross Pension = Earning Points x Type Factor x Accrual Factor x Pension Point Value P(t) = ∑ EP x type x accrual x ppv(t)

Page 16 Indexation within Statutory Pension System Calculating a monthly pension The general equation for monthly gross pensions Accrual Factor: accounts for early or late retirement deductions of 0.3% per month increases of 0.5% per month Gross Pension = Earning Points x Type Factor x Accrual Factor x Pension Point Value P(t) = ∑ EP x type x accrual x ppv(t)

Page 17 Indexation within Statutory Pension System Calculating a monthly pension The general equation for monthly gross pensions Example: Fritz is born 1950 worked 40 years with average yearly earnings retired 2015 at the age of 65 Gross Pension = Earning Points x Type Factor x Accrual Factor x Pension Point Value P(t) = ∑ EP x type x accrual x ppv(t) P(2015) = 40 x 1.0 x x EUR = 1154,38 EUR

Page 18 Indexation within Statutory Pension System Indexation of Pensions Pensions are annually indexed on 1st of July Wage Factor: Increasing Pension Point Value when wages increase Waverage gross wages cWcontributory gross wages ppv(t) = ppv(t-1) x Wage Factor x Contribution Factor x Sustainability Factor

Page 19 Indexation within Statutory Pension System Indexation of Pensions Pensions are annually indexed on 1st of July Contribution Factor: Increasing Pension Point Value when contribution rate decreases CRContribution Rate Statutory Pension oCRmax. subsidized Contribution Rate to Occupational Pension ppv(t) = ppv(t-1) x Wage Factor x Contribution Factor x Sustainability Factor

Page 20 Indexation within Statutory Pension System Indexation of Pensions Pensions are annually indexed on 1st of July Sustainability Factor: Increasing Pension Point Value when Share of Pensioners decreases αParameter α = 0.25 RQShare of Pensioners ppv(t) = ppv(t-1) x Wage Factor x Contribution Factor x Sustainability Factor

Page 21 Indexation within Statutory Pension System Indexation of Pensions Example: Indexation in 2010 (Germany West) ppv(2010) = EUR (-2.1%) A “Protective Clause” prevents from decreasing pensions ppv(2010) = ppv(2009) = EUR (±0.0%) ppv(t) = ppv(t-1) x Wage Factor x Contribution Factor x Sustainability Factor = EUR x x x

Page 22 Indexation within Statutory Pension System Indexation of Pensions Protective Clause and Counterbalancing Factor Protective Clause in 2005, 2006 and 2010 yield to a Counterbalancing Factor of 3.81% (West Germany) counterb. factor t-1

Page 23 Indexation within Statutory Pension System Indexation of Pensions Reducing the Counterbalancing Factor cumulated up to 2010 ppv t-1 Δ ppv, increase ½ increase ppv t counterb. factor t-1 reduced counterb. factor t

Page 24 Indexation within Statutory Pension System Indexation of Pensions Example: Indexation in 2011 (Germany West) ppv(2011) = EUR (+1.99%) Applying the Counterbalancing Factor: ppv(2011) = EUR (+0.99%) Reduced future indexation compensates for omitted cuts. ppv(t) = ppv(t-1) x Wage Factor x Contribution Factor x Sustainability Factor = EUR x x x

Page 25 Indexation within Statutory Pension System Summary Pensions reflect individual life-cycle income Entitlements result from a relative earning position Yearly indexation, but no pension cuts Wages Contributions Relation between contributors and pensioners

Time for Questions François Peglow Federal Ministry of Labour and Social Affairs, Germany «Principles and Methods of Financing Old-Age Security Systems»