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The Reform of the German Pension System

By Georg ErberPresentation at the Faculty of Economics at the Thammasat UniversityMay 2, 2008

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Introducing myself

I am working at the German Institute for Economic Research, DIW Berlin

I have been teaching a couple of times as Visiting Professor at the Department of Economics of the Thammasat University here in Thailand

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There is no Free Lunch

Pension systems are very expensive social security systems

They can absorb 20 to 30% of the actual workers gross income in Germany

They even need significant additional tax subsidies for financing

Three pillars of the German System (obligatory pension payments, company based pension schemes and voluntary individual pension schemes Riester and Ruerup pensions)

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Topics of Discussion

German Pension System Aims and Key Elements Key Challenges Potential Options for Setting-up a Thai

Pension System Necessary Knowledge Base needed to make

it sustainable

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German Pension System

Historic origins Introduced by Bismarck in 1891 as final part

of social security legislation At first intended to support the fight against

the labour movement by offering an alterative way instead of a revolutionary movement then headed by the Social Democratic Party to obtain full political power

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Aims of the German Pension System - Then

When introduced offering financial support for workers older then 65 (average life expectation at this time was 67 year) and widows of workers and their children to avoid poverty

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Aims of the German Pension System - Now

Before Reform: Guarantee a living standard close to the one obtained during working age (before reform: about 73% of the last wage or salary income)

After Reform: Lowered to about 54% after the reform, which however gradually reduce this pension payments by 2030, close to the welfare payments for each citizen making it highly unattractive for the young generation

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Traditional Key Elements

Legal Framework: (Social Security Laws) set by the German Parliament

Obligatory: Every employee should contribute to the system to include an workers

Dynamic: Should be linked to the overall economic development, i.e. compensate for inflation and income growth of the rest of the population (dynamic adjustments of pensions)

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continued

Pay-as-you-go-system (beginning with contributions of 15% of their gross income – are paid by employed workers are used to pay current pensioners)

low tax subsidies of about 15 to 16 % by government in1989

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Changing Key Elements

Due to a significant increase part-time and low paid jobs the obligatory payments of contribution into the pension system is no longer guaranteed (workers are increasingly falling through this net)

Weakened link between pension incomes and general income development, slower increases in pensions compared to the overall income growth

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continued

Maintain the core pay-as-you-system (now at 19.9% of gross income) but complement it gradually

by capital based financing (Riester pensions: 4% of gross workers income)

by company-based pension systems: about 5-7% of gross workers income)

Significant increase in tax subsidies (now 25% and increasing further)

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Key Challenges

Demographic Change Changing Employment Biographies Changing Financing System (contributions by

employers and employees versus increasing tax subsidies)

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Demographic Change

Demographics in Germany have and are further changing dramatically and unfavorably leading to an aging society

Low birth rates 1.3-1.4 children per woman, below the sustainable population rate of 2.1 child)

Increasing life-expectation in Germany (currently 76 years for men, 83 years for women)

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Population Development in Germany1950 until 2050

http://www.berlin-institut.org/fileadmin/user_upload/Aktuelles/Deutschland.swf

http://www.berlin-institut.org/index.php?id=48

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Changing Employment Biographies

Life-long full-time employment has lost dramatically ground

Part-time employment and longer spells of unemployment are increasing diminishing life time worker incomes considerably

Rapid technological change and globalization lead to a diminishing value of workers experience obtained at a job in a particular company leading to lower incomes after losing such jobs

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Changing Financing System

Complementing the pay-as-you-go system by capital-based financing

Due to diminishing payments into the obligatory system there emerged a structural deficit

This led to rising costs for those still contributing e.g. from 15 to 19.9% making labor less competitive due to high wage costs

Further general tax subsidies increased from 15% to more than 25%

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continued

Introduce additional elements like voluntary company pension capital-based systems negotiated between trade unions and companies to compensate for pension losses from the obligatory system (by offering tax-incentives)

Introduce voluntary individual capital-based pension systems (Riester and Ruerup pension schemes) again offering tax incentives

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continued

Longer education time in Germany at school (43% obtain a college degree) and universities (33% obtain a university degree) for higher education reduce overall employment time

Young and older people in the job market face steep barrier to entry to obtain well paid full-time jobs

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Potential Options for Setting-up a Thai Pension System

Define the aims properly according to social justice and take care of sustainability

Avoid free-rider problems Pay-as-you-go system versus capital-based

financing or mixed system How much tax subsidies are needed?

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Necessary Knowledge Base needed to make it sustainable

Need for an accounting framework for demographic change and intergenerational accounting (see e.g. Kotlikoff ) http://ideas.repec.org/e/pko44.html#works or

Peter F. Bell The Economic Impact of Demographic Change in Thailand, 1980-2015: An Application of the HOMES Household Forecasting Model. by Burnham O. Campbell; Andrew Mason; Ernesto M. Pernia, The Journal of Asia

n Studies, Vol. 54, No. 2 (May, 1995), pp. 618-620   Political debate needs facts about the future

trends and consequences of different solutions

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EXPECTATION OF LIFE AT BIRTH FROM THE SURVEY OF POPULATION CHANGE in Thailand

Year of Survey Life Expectation

Male Female

1974-1976 58.0 63.8

1985-1986 63.8 68.9

1989 65.6 70.9

1991 67.7 72.4

1995-1996 69.9 74.9

Source : Report on The 1995-1996 Survey of Population Change, National Statistical Office.

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Source: http://thailandeconomy.blogspot.com/2007/12/thailands-demographic-window-of.html

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Region 1995-1996 1991 1985-1986

Whole Kingdom 2,022.0 2,173.5 2,730.0

    Municipal Area 1,331.6 1,370.0 1,766.0

    Non-Municipal Area 2,284.7 2,436.5 2,962.0

Bangkok Metropolis 1,260.7 1,134.5 1,735.0

Central Region (Excluding Bangkok Metropolis)

1,664.4 1,954.0 2,494.0

Northern Region 1,894.3 1,972.0 2,248.0

Northeastern Region 2,435.3 2,665.5 3,096.0

Southern Region 2,850.9 2,982.0 4,049.0

TOTAL FERTILITY RATES BY REGION in Thailand 1995-1996, 1991 AND 1985-1986

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What This Means

Thailand will need a public pension system reform, the current system will be insufficient

There is no time to waste since due to the compound interest rate factor for delays later pensioners will pay dearly

It is time to act now to draw a realistic plan to avoid mass poverty later

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Compound interest rates factor

assuming an 5% real interest rate 1000 Bhat invested now gives a return of

7040 Bhat in 2048 1000 Bhat invested in 2013 gives a return of

5516 Bhat in 2048 or 28% less than invested five years earlier

1000 Bhat invested in 2018 gives a return of 4322 Bhat in 2048 or 63% less than invested ten years earlier

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Next Steps

Establish the necessary facts for the policy debate in Thailand

See e.g. the following literature http://www.ier.hit-u.ac.jp/pie/Japanese/discussionpaper/dp2003/dp201/text.pdf

Start a debate on the aims and scope of a public pension system