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Pension Funding in Germany |
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 Germany is well-known as a country with many unfunded pension
liabilities. Most German companies back their pension
commitments with company assets, and pension benefits are paid to pensioners
directly from the company. German tax legislation has historically
favoured this “direct pension commitment” approach, in contrast to the
separate funding found in most other countries.
Far more than half of all pension obligations of German employers are
in the form of these direct commitments. Although not required by law,
many employers in recent years have moved to match pension obligations
with external funding investments. Today, roughly 40 percent of direct
commitments have been matched with external investments, either in the
form of insurance policies or mixed bond and equity portfolios. These
assets are still treated as company assets and are shown as such on the
balance sheet. And they also may, in most cases, be used for other
purposes than paying pensions.
This concept of matching assets to pension liabilities has gained
traction in recent years, driven by several external pressures. This
article will take a look at some of the issues driving this trend and
identify areas of further analysis that sponsors of German pension
plans may want to explore.
Increased visibility of pension risks
With the adoption of US-GAAP and IAS/IFRS, new opportunities became
available to transform existing company assets into pension plan assets
without negative tax implications. DaimlerChrysler and Siemens were the
first major German companies to set up pension trusts for their
existing defined benefit (DB) plans in 1999/2000. Additionally, some
companies have taken the opportunity to fund pensions through qualified
insurance policies.
US-GAAP and international accounting standards have made pension risks
more visible than the former German GAAP, which calculated liabilities
with a fixed annual discount rate of 6 percent. This rate typically
understated plan liabilities in today’s market conditions and also
failed to value mandatory pension indexation required under German law.
Along with the accounting issues noted above, the decline in interest
rates over the past several years has greatly increased pension
liabilities, creating concern for plan sponsors. Finally, actual and
anticipated improvements in retiree longevity will place more strain on
pension liabilities, which plan sponsors may want to back with assets.
Advantages of prefunding pension liabilities
There are several advantages to creating an asset vehicle that qualifies as plan assets under IAS 19 or US GAAP.
The transfer of existing company assets to the new vehicle may lead to
the immediate recognition of capital gains (or losses) at the moment of
transfer that have not previously passed through the profit-and-loss
account.
Under current accounting guidelines, investment gains and losses
incurred after the transfer may be deferred if an “amortization
corridor” approach is used. Unexpected changes in the fair value of
plan assets are treated as actuarial gains and losses and may be
amortized over a period of time. This amortization may be further
blunted by the use of the 10 percent-corridor, which is used by almost
all German companies that report under US GAAP and IAS 19. This means
that variations in the fair value have less effect on company earnings
than if they were regular company assets.
There may also be a positive effect on company earnings where the
expected return on plan assets lowers pension expense and enhances
operating income – though financial income becomes lower in exchange
because the former assets are now plan assets and are no longer
generating financial income.
The pension trust provides additional protection against insolvency for
benefits not covered by the state protection limits because these
benefits are too high or the vesting period has not expired.
CTAs: A potential solution?
In Germany, a contractual trust arrangement (CTA) is a reliable way to
convert existing company assets into pension plan assets that are
recognized under FAS 87 and IAS 19. This is a complex legal framework
that can be created without changing the investment structure or tax
treatment of those assets. Nearly half of the companies listed in the
DAX 30, and many German subsidiaries of foreign corporations, already
have such a CTA in place. Contributions to CTAs are considered company
assets and do not represent taxable income to employees.
A CTA may even qualify as a “trust or an equivalent of a trust” under
US Internal Revenue Code section 404A if additional conditions are met.
Section 404A stipulates how US taxpayers can claim tax deductions or
reductions in earnings and profits with respect to non-US deferred
compensation plans.
There are signs that the trend toward CTAs is likely to continue among
the larger companies and spread to smaller and medium sized
organizations. While one can see the advantages of clearer accounting
and additional benefit security for driving the change, there are other
consequences. The main disadvantage of CTAs is that the transferred
assets may no longer be used for other purposes, such as capital
expenditures or acquisitions.
Is there another alternative?
The new “Pensionsfonds”, introduced in 2002, made it possible to make
tax-favourable asset transfers to unfunded pension commitments without
creating a tax liability for the employees concerned. Companies can
extinguish their past-service pension liability by making a transfer to
a Pensionsfond. We have also seen some organizations use the
Pensionsfonds approach in M&A situations for small obligations when
the buyer is highly resistant to taking responsibility for any pension
obligations.
Unfortunately, Pensionfonds are required to calculate their liabilities
on a very conservative basis, similar to that used by insurance
companies when pricing annuity business. Thus, the amount that would
need to be transferred to “buy-out” plan liabilities is far more than
companies would typically hold on their accounting books for those
liabilities. Such a transfer is also treated as a settlement under IAS
19.
At the moment, there is hope of legislative developments that would
diminish the necessity for such a large contribution to finance the
past-service liability, which could make these transfers more
attractive. But any advantage of this approach must be weighed against
the fact that if transferred assets plus future returns prove to be
insufficient to pay promised benefits, the company would need to make
up any shortfall.
Other tax legislation in 2001 and 2004 enhanced the tax-efficiency of
combinations of different financing vehicles in hybrid plans with
defined contribution and defined benefit elements. If properly
structured, these plans can have the same tax effectiveness as a DB
plan, while lowering employer risk.
Conclusion
German employers with unfunded pensions should analyse their financial
position regarding pensions, particularly if they have invested company
assets to pay future pensions. Thoughtful financial engineering can
improve both accounting treatment as well as insolvency protection
without changing employee benefits. Employers should also review their
pension plans to see if they can benefit from these new tax rules.
Finally, companies should reassess the true underlying risk they are
carrying with their pension plan commitments, reviewing not only
funding plans but also asset strategies, benefit design, and accounting
implications.
 Raimund Rhiel. Raimund is head of Mercer’s retirement
business in Germany. He has over 20 years of experience in actuarial
services and lectures on actuarial and econometric topics at Marburg
University. Raimund has published widely and is an expert on national
and international accounting rules.
Obtained from Mercer Human Resource Consulting
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