September 14, 2009
The financial market crisis and global economic recession are leaving deep scars in many places, and pensions are no exception. However, state-incentivised private retirement provision in Germany is far less seriously impacted than many pension plans in other countries. Private pension schemes should not abandon investment on the capital market. A return to the unrestricted dominance of state pensions would be quite the wrong policy.
The financial market crisis has rekindled the old debate on the “architecture” of retirement pensions. Advocates of the welfare state are calling for a U-turn in pension policies and a return to the unrestricted dominance of the pay-as-you-go (PAYG) state pension. In their view, the financial market turmoil in recent years shows that fully-funded systems, unlike national pension schemes, do not provide a reliable basis for financial provision for later life.
Such indiscriminating criticism is misplaced. Neither are the state welfare systems left unscathed by the crisis, nor are all fully-funded retirement savings products affected equally severely by the financial market upheaval. It is correct that the state systems are currently helpful inasmuch as they offer pensioners stable incomes in the depths of the crisis. This is desirable in social policy terms and can help stabilise the economy. But the state systems are living beyond their means. They are having to use up financial reserves or require subsidising, which puts pressure on the public purse. Only if the economy and employment stage a thorough recovery will the crisis do no more than dent pension finances. Precisely in Germany, however, this is uncertain. Here, high social security contributions threaten to help harden cyclical unemployment as well. This would be all the more awkward in that the demographic problems of the PAYG system remain.
Legislators in Germany have already addressed the demographic shift and reduced a large part of the implicit government debt for the future by making cuts in state pensions, most importantly by adjusting the pension benefit formula and gradually raising the retirement age to 67. Those who now argue in favour of turning the clock back on these reforms are jeopardising the German economy’s growth prospects and the sustainability of public finances by factoring too heavy a burden on future tax and contribution payers into the equation.
It is therefore still up to individuals to make more private retirement provision. There is no viable alternative – apart from a statutory retirement age way beyond 70. The crisis has not called the logic of additional private provision into question, although, increasing joblessness and uncertain employment prospects will make it more difficult to set savings aside monthly for later life. Private pension plans featuring flexible contribution options could be helpful here. When people make their own provision, there is a greater incentive to work more in the official economy, whereas the PAYG system has a counterproductive effect in this respect in ageing countries. What is more, increased provident savings improve the economy’s endowment with capital. This is no less important to secure the country’s innovative capacity and productivity. In an ageing society productivity gains are a mainstay of the PAYG system too. Those who have no faith in fully funded pensions should not expect much from the PAYG system either.
To protect investors, legislators in Germany have obliged providers of state-subsidised private retirement provision to guarantee the nominal value of the contributions into such private products at the beginning of the disbursement period, i.e. as a rule when the recipient retires. Owing to these guarantee commitments, coupled with strict regulations on investment in the case of conventional insurance products and other pension institutions’ general investment policy focus on the principle of prudence, retirement assets in Germany are invested more conservatively in general than in other countries. In Germany, state-incentivised private provision has been far less severely impacted by the crisis than many private pension plans in the USA, for example.
But it would be wrong to conclude from this that retirement savings in general should be invested very conservatively and only a small proportion held in shares. That would be to disregard the power of the compound interest effect. When precautionary saving has a long time horizon, as is the case with younger and middle-aged savers, it should continue to focus on growth-oriented investment strategies. In principle, as investors grow older it is advisable to switch to more conservative investments.
Particularly in the case of long-term investment horizons, the recent turmoil is no reason to take retirement savings out of the capital market. On the contrary, as well as offering the prospect of higher returns, stock market investments tend to boost the economy’s potential growth more powerfully than, say, commitments in government bonds. Admittedly, the crisis has shattered the illusion sometimes entertained in the face of high returns in the past that the compound interest effect alone is by and large sufficient to provide adequate retirement income. There is a limit to everything, even on the capital markets. For much of the working population this means that they need to channel far higher savings into private financial provision than hitherto assumed. This calls for appropriate effort. In an ageing society more private provision is indispensable for financial security in retirement, but it will not be achieved in sleep mode.
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