The landmark law authorizing German private pensions creates a huge market. Catch is, a few firms may end up with most of the money.
By Andrew Capon
November 2001
Institutional Investor Magazine
At 59, Reinhard Stricker has already entered his golden years. When the regional utility where he was a senior manager merged with another in 1997 to form EnBW - for Energie Baden-Württemberg - Stricker took early retirement. His former employer pays him a monthly pension, and in 2003 he will start collecting state benefits.
But although he lives fairly well, in a leafy, middle-class suburb of Stuttgart, Stricker thinks his future could have been twice as golden. He has contributed the maximum to social security all his working life, and he feels the German government has let him down.
“If I had paid the same amount into private insurance,” he gripes, “I could have expected double the benefit.”
Millions of German workers are about to test Stricker’s assumption. After years of denial and political wrangling, Berlin has launched pension reform, admitting that its vaunted social welfare system is headed for trouble. In legislation that is at once momentous and modest, Germans will be allowed to make small, tax-deductible contributions from their salaries to private retirement accounts, beginning in January 2002. “For the first time, politicians have grasped the nettle and sent a very clear message to citizens that they cannot rely solely on the state,” says Maximilian Zimmerer, chief financial officer of Allianz Lebensversicherungs, the life insurance arm of Germany’s top insurer, Munich-based Allianz.
The pols had little choice. A quarter of Germany’s working population is 65 or older, and by 2030 that number will climb to nearly 45 percent. At present two workers support every retiree, but by 2030 the ratio is expected to be just 1-to-1, compared with 2.1-to-1 in the U.S. Thanks in part to a low birthrate and a general population decline, Europe’s biggest economy will also be its oldest nation within three decades. Already, Germany devotes 12 percent of its gross domestic product to government-paid retirement benefits - in the European Union, only Italy shells out more. And according to the Organization for Economic Cooperation and Development, without pension reform the cut would rise to 18.5 percent by 2035.
The legislation passed in May to ease this inordinate burden on the state - called the Riester plan, after Labor Minister Walter Riester - doesn’t go nearly as far as its author had originally hoped. To push the law through, the government had to load it with features designed to reassure the populace that private pensions will be as secure as government benefits. Nevertheless, money managers inside and outside Germany are drooling over the potential new savings pool. Deutsche Bank Research conservatively estimates that E8 billion ($7.3 billion) will flow into Riester pensions in 2002 alone, and that cumulative contributions could reach as much as E180 billion by 2008. Morgan Stanley, using more liberal assumptions regarding eligible retirees, is far more bullish, projecting as much as E53 billion in 2002 and total funds of up to E550 billion by 2008.
With so much money at stake, would-be providers are eagerly trying to stake out territory. Because Riester plans must guarantee contributions at redemption - a safeguard the government was forced to include - insurers are likely to be the new market’s early winners.
Allianz is pouring millions into advertising and had already sold 125,000 Riester plans by October 1, months before the tax breaks become effective. Axa Colonia, the German arm of giant French insurer Axa, began offering Riester products in May. Aachen-based insurer AMB Aachener und Münchener Beteiligungs, the third-biggest player in German life insurance and No. 1 in mutual-fund-linked policies (the market’s fastest-growing segment), is offering three variations on the Riester theme: an insurance policy with no fund investment, an insurance product that pays its profits into a mutual fund and a fund-linked policy.
Allianz’s Zimmerer thinks insurers will control 60 to 70 percent of the Riester market. “It’s not an easy product to structure,” he says, “but there is scope to be inventive, and we think we have the right mix to sell to clients.”
Meanwhile, Germany’s Big Three mutual-fund families - Deutsche Bank’s DWS Investment, Deka Group and Union Investment (Institutional Investor, October 2001) - are awaiting regulatory approval for their Riester products from the Insurance Supervisory Office before they start marketing aggressively. DWS points out that fund managers face a harder job designing Riester pensions than do insurers, which can simply trot out variations on existing products. So it has been more cautious about early sales pitches. DWS started marketing its Riester products in mid-October, putting its brand-awareness machine to work on television and radio as well as in print and direct mail.
The new money will go into two kinds of accounts introduced by Riester reform: individual and occupational pensions. In the individual plans, Germans can pick their own providers and can set aside 1 percent of their gross salaries starting this January and up to 4 percent by 2008, taking an income tax deduction for the contribution. Companies will be able to set up occupational pensions, or Pensionfonds, making tax-deductible investments on their workers’ behalf - with or without employee contributions. Unions, together with their employer association counterparts, can establish industrywide schemes. Meanwhile, Berlin will gradually reduce the typical German worker’s government benefit from 70 percent of net salary to 67 percent by 2030. (That reduction represents a major concession to the country’s unions: Originally, the reform called for benefits to drop to 64 percent.)
As the responsibility for funding retirement shifts from the state to the individual, more and more people will be in the market for long-term investment vehicles, be they Riester pensions or taxable mutual funds. And since Germans buy more than two thirds of such products at bank branches, providers with ties to banks will have a selling edge. Allianz has begun retraining clerks at Dresdner Bank’s 1,360 branches to peddle a range of insurance and investment products - a crucial backup to its 12,000-strong army of insurance agents. Deka is teaching representatives to sell Riester products at the 20,000 branches of Germany’s 600 Sparkassen, or savings banks, which are its principal owners. Union Investment will push its Riester plans and mutual funds at the 16,000 branches of Germany’s cooperative banks.
All players expect Riester pensions to take off in time. “If you say to a typical German investor that the state wants to give him a tax break if he buys a pension fund, he will only want to know where to sign the contract,” says Harald Lechner, managing director of MEAG, Munich Reinsurance Co.'s asset management arm. Adds Elmar Werner, head of product development at Union: “It’s another form of saving, which should be welcomed.”
Because it relies on the carrot of tax breaks, not just the stick of reduced government benefits, the Riester plan is more complicated than the pension scheme introduced in Sweden last year, which simply rerouted a small portion of Swedish workers’ compulsory social security contributions into private accounts. But tax breaks work, as proved by the runaway success of personal equity plans in the U.K. and plans d'épargne en action in France. French workers have socked E100 billion into PEAs since the plans were introduced in 1992; their British counterparts have E114 billion in PEPs and the more recently invented individual savings accounts. In the U.S. the 401(k) market is worth $1.76 trillion.
The big question for fund providers is whether the jumpstart that insurers got in rolling out individual Riester pensions will give them a lasting advantage in the retirement market - especially once the corporate Pensionfonds are introduced. Regulations for Pensionfonds won’t be issued until next year - three drafts are circulating - so it’s not clear precisely how they will work. But the tax advantages for employers make it likely that many companies will adopt them. And if, as anticipated, Parliament approves investment guidelines for the Pensionfonds that are less stringent than those for individual Riester accounts, occupational plans could eventually attract the bulk of the new pension money. This is the segment of the market where mutual fund companies, with their more growth-oriented approach to fund management, could eventually overtake the insurers.
Joachim Schwind, chairman of Pensionskasse der Mitarbeiter der Hoechst Gruppe, one of Germany’s largest funded retirement pools, with Dm9.5 billion ($4.3 billion) in assets, is unwilling to say for certain whether chemical giant Hoechst intends to introduce occupational Riester funds. But, he says, “the reform should lead to a significant increase in external financing of pensions in Germany, which have not seen substantial growth in recent times. It gives companies a greater degree of flexibility in choosing the right vehicle to fund retirement benefits.”
Today the Dm620 billion (E317 billion) of assets in company-backed retirement plans is the equivalent of just 11 percent of Germany’s gross domestic product, compared with 87 percent in the U.K. Researchers at Deutsche Bank and at mutual fund group Deka think that in the medium term, about a third of Riester plans will be occupational. Using Morgan Stanley’s projections, that would mean upward of E183 billion in additional pension assets by 2008.
Like individual Riester plans, Pensionfonds must guarantee contributions at redemption, even if the company makes all the deposits. All contributions, for employees and employers alike, are tax-deductible - for companies, they are booked as operating expenses. Contribution amounts will phase in on the same schedule as that for individual plans: Starting in 2002 companies will be able to earmark 1 percent of an employee’s gross salary for a Pensionfond. The maximums will rise to 2 percent in 2004, 3 percent in 2006 and 4 percent in 2008. Theoretically, a German worker who participates in an occupational plan could save as much as 8 percent of his salary for retirement. Most people, analysts say, are likely to opt for occupational plans when they are available, because the company contributions are such an incentive.
Pensionfonds are where fund managers that cater primarily to the institutional market hope to make their mark. They worry that it will be tough to compete with distribution powerhouses like Allianz and Deka in marketing individual Riester pensions. "[Company plans are] our core business, a market we understand,” says Robert Hegt, head of developing European institutional business for Schroder Investment Management International. “I am confident that in time, occupational schemes will grow to be far larger than the individual Riester plans.”
German industrial companies have been lobbying the government hard to ensure that the regulations allow them the flexibility to invest their pension assets in the most effective way. To that end, 13 of Germany’s biggest corporations - including Bayer, BMW, DaimlerChrysler and Volkswagen - this summer formed the Pensions Industry Circle. The PIC wants the government to abandon quantitative rules that dictate how much pension funds can invest in certain assets, in favor of the prudent-man principle that governs the investment decisions of U.S. and U.K. money managers.
Lutz Cardinal von Widdern, global head of employee benefits at chemicals and pharmaceuticals giant Bayer in Leverkusen, thinks the PIC has a good chance of getting its way. “We have been pleasantly surprised by the attitude of the government in discussion papers we have seen,” he says. But like his counterparts at other major industrial companies, he is reluctant to discuss Bayer’s specific plans for setting up Pensionfonds before the regulations are on the statute book.
Pensionfonds represent a significant reform of the whole corporate pension system because they are expected to be free to seek high returns in stocks while also providing major tax breaks. Companies could find Pensionfonds an especially compelling alternative to the now-prevalent book reserve, which are assets held on companies’ balance sheets and paid out to retired employees. The Riester legislation will allow companies to transfer book reserve assets into Pensionfonds without taking a tax hit, most experts believe. Gains would be realized, but the transfer would be a tax-deductible expense.
“Companies such as Bayer that have book reserves will make a decision partly driven by financial and balance-sheet considerations,” says von Widdern, who also is a director of Bayer’s Dm12 billion Pensionskasse, or captive insurance fund, which is Germany’s largest. “But not until the regulations are established and after perhaps years of study.”
About 60 percent of the Dm620 billion in German corporate pension obligations is in the form of book reserves. During Germany’s postwar expansion, these reserves constituted an efficient financing tool, because companies could borrow against them cheaply. But on-balance-sheet pension financing is coming under pressure. For a start, the introduction at year-end of International Accounting Standard 39 will force German companies to book at fair value financial instruments available for sale, including special-purpose vehicles such as Spezialfonds, a key category of book reserve. Many think IAS 39 will remove the Spezialfonds’ current tax-privileged status. Moreover, the draft European Union pensions directive governing all EU members does not recognize book reserve - even in the guise of Spezialfonds - as a valid pension structure.
Foreign fund managers would welcome the demise of Spezialfonds. By law, they can be managed only by special entities called Kapitalanlagegesellschaft, whose rules and regulations are so onerous and expensive that foreign firms have long suspected them of being a deliberate attempt to stymie competition. The case for transforming other types of company pensions into Riester Pensionfonds is less clear-cut. But the stakes are almost as high: Dm254 billion is held in the non-book-reserve vehicles, principally in captive insurance funds, or Pensionskassen.
Money managers are waiting with their fingers crossed to see how the government regulates Riester Pensionfonds, since the rules will determine how many companies start them. “What will be watched very carefully are the new investment guidelines of the insurance act, which will also regulate the new Pensionfonds,” says Olaf John, Fidelity Investments’ head of German institutional business. “Pensionskassen are insurance companies and therefore have a maximum equity investment limit of 30 percent. The new guidelines for Pensionfonds are expected to be more liberal and therefore more attractive.”
Reform will also probably lead companies to broaden their manager base. Schroder’s Hegt is absolutely confident that Pensionfonds will be regulated more liberally than individual Riester plans. “Pensionfonds will look much more like U.S. or U.K. plans and will be following prudent-man investment rules,” says Schroder’s Hegt. “This presents an opportunity for a wider range of managers, both German and international.”
But the popularity of Pensionfonds will also depend on the attitude of Germany’s powerful trade unions. Though they bitterly opposed the Riester reforms as undermining the German welfare state, many will nonetheless now push for Pensionfonds as a benefit. “It will be interesting to see how high this is on the agenda during the next round of pay negotiations,” says Deutsche Bank Research senior economist Dieter Braeuninger. Megaunion IG Metall and the employers’ association Gesamtmetall have already agreed to establish an industrywide fund. They estimate that 1.8 million metalworkers who are not covered by company schemes will participate in the fund, which is expected to be worth Dm8 billion within a few years.
Thomas Bergenroth, head of State Street Germany in Munich, thinks pooled cross-industry pension schemes will also be adopted by groups of Mittelstand companies that don’t want to go to the trouble and expense of establishing plans of their own. “In ten years’ time the German occupational pension market may look similar to the Netherlands, with company schemes run by only the biggest employers and a relatively small number of large cross-industry plans,” he says.
Yet far from gloating over a long-awaited windfall, some money managers are grumbling. That’s because to push Riester pensions through, the government had to make them look like airtight investments to the German populace. So the reforms come with enough strings attached to make providers feel like marionettes. The stipulation that all contributions must be guaranteed at redemption is likely to give insurance providers an initial edge over mutual fund companies and equity-oriented asset managers.
“This is a typically German compromise,” mutters Morgan Stanley’s Peter Koenig, head of the global pensions group in Frankfurt. “You might concede the point that it was necessary to offer investors some level of comfort and security, but this is not the way to do it. It is too blunt an instrument.”
The complex, bureaucratic rules buried in the minutiae of Riester reform echo the stakeholder pensions introduced by Tony Blair’s New Labour Party, the U.K.'s ideological counterpart of Germany’s Social Democrats. These funds, established in April, were designed to provide funded retirement schemes for low-income workers, the self-employed and those at companies too small to offer an occupational scheme. They are so nightmarish to administer that they have been an unmitigated failure. More than 200,000 small companies were unable to establish the schemes in time to meet this October’s deadline, and they could face fines of $16 billion.
As with stakeholder pensions in the U.K., Riester savers can chip in tiny monthly amounts, as little as Dm5. That makes offering Riester pensions uneconomic for many providers, not to mention an administrative nightmare. What’s more, the government is demanding that providers be much more forthcoming about fees and distribution costs than they are with mutual funds or nonretirement insurance products.
And each Riester pension product must be approved by the Insurance Supervisory Office, which could send some providers back to the drawing board. The vetting process concerns Christian Klausenberg, head of life insurance and underwriting at Munich Re, for another reason. “It’s like these products will have the government seal of approval,” he says. “That is dangerous, because it is not easy for consumers to tell the difference between an approval that says this product meets the mandated criteria and an approval that says this is a good product that is safe to buy.”
The upshot of all these conditions and stipulations is that the Riester pension market has put off some potential providers. Fidelity, the largest foreign fund manager in Germany, for instance, says that it won’t offer a Riester product for individuals unless it can find a joint-venture partner that can manage the accounts’ administration and guarantees. “The devil is in the details, and the details are what may put us off offering a Riester product,” says Fidelity’s John. “It would be too expensive and too much of a burden on administration and systems.” John maintains that a reasonable case can be made for not buying a Riester pension, since the guarantee will compel providers to invest mainly in relatively sure things like bonds. “Over the life of the pension, even with the deferred taxation, an investor may be better off with an equity mutual fund,” he contends.
It’s telling that Allianz’s life insurance arm, not its asset management division, is marketing Riester pensions. The pensions’ structure, guarantee and the fact they must eventually be converted into annuities all favor insurers. Indeed, rival bank and fund firms grumble that the Riester reforms were biased in favor of insurers, because of the clout of the seasoned German insurance lobby.
Undeniably, insurers have an enviable sales record in Germany. As Munich Re’s Klausenberg jokes, “Eighty million Germans means 80 million insurance policies.” And the insurers are experienced at pitching the things that mean most to German consumers: security and tax relief. Allianz ran 19,000 television ads for its individual Riester plans between July and October, urging savers to make the most of the new tax breaks. The company is offering two products: a traditional annuity that will invest up to 30 percent in stocks and a hybrid policy linked to both an endowment and a mutual fund whose premiums will be split in two. The hybrid structure will allow workers to decide how much equity risk they want to take. If they choose a stock fund for the mutual-fund-linked part of their pension, as much as 70 percent of their overall allocation could be invested in equities.
Moreover, sprawling proprietary distribution networks should give insurers an edge in selling supplementary retirement products. That could prove critical, as commissions on Riester pensions are to be stretched out over ten years, so that more money gets invested up front. Basically, the incentive to peddle a Riester pension will come down to the chance to sell other, more remunerative products, such as mutual funds and health insurance. As Allianz’s Zimmerer puts it: “The reform as it stands does not represent a complete solution for retirement needs. But there is a tremendous cross-selling opportunity here. The funding gap left by the Riester reform needs to be filled with other products.” The premium on cross-selling shuts out firms, like Fidelity, that must rely for distribution on independent advisers that prefer to deal in big-ticket mutual funds.
Insurers, accustomed as they are to collecting monthly policy bills, are also in a good position to cope with the administrative burden of harvesting and accounting for small, regular payments from Riester pensionholders. And they are comfortable with providing guarantees, as they do on endowment policies. Nevertheless, only big, technologically sophisticated insurers - or banks or fund companies, for that matter - will find the Riester market economical. Even Allianz, which expects to grab a 15 percent market share in individual Riester products and more than 20 percent in occupational Riester plans, doesn’t look forward to making money on them anytime soon. The Munich-based insurer estimates it will take ten years to make a profit out of Riester. That suggests other providers may regret chasing Riester business.
Another advantage for the insurers is that pension reform comes at a bad time for the German mutual fund industry. Flows into equity mutual funds through the end of July, the latest figures available, were just E5 billion, and given the weakness of global markets, it seems highly unlikely that inflows will come close to matching last year’s E47 billion total. It could hurt the mutual funds that they were cheerleaders for the equity cult that took hold during the late 1990s. Stodgy, dependable insurance companies, a turnoff during the go-go markets of the recent past, might look more attractive to chastened investors now.
The fund providers aren’t utterly cowed. DWS expects to get a 20 percent market share of tax-advantaged retirement products, close to its 22 percent share of the German mutual fund business. “The provider that can really educate the public will win a bigger part of the cake,” says Deutsche Bank Research senior economist Braeuninger.
At rival Deka, Ulrich Gallus, managing director of fund administration and asset management, says the fund families will make a massive effort to persuade German savers that equity-weighted mutual funds are as safe as conventional insurance policies. Gallus believes that at least among younger Germans, a shift in attitude can already be detected. “I think most Germans between the ages of 25 and 35 now accept that in the long run, equity investment will give them better returns without substantially higher risk. The mentality of savers is changing.”
For instance, Reinhard Stricker says that to his generation, mutual funds and the stock market seem too risky. However, he expects that his children will provide for their retirements using a mix of property, insurance, funds and stocks.
Guaranteeing that customers will get their money back is of course contrary to the ethos of an investment firm. But considering the stakes involved in Riester pensions, many firms appear to be developing a new flexibility. Union’s Werner points out that, “depending on the time remaining for the pension plan to reach maturity, interest rates and the performance of equity markets, we will decide what the asset allocation should be” and thereby assure pensionholders of getting back at least the money they put in, as required by law. The closer to retirement, the lower the customer’s risk profile. Back-testing by Union purports to show that this is the most sensible way to offer both a guarantee and optimal returns.
The guarantee may look absurd through Anglo-Saxon eyes, but is an important safety blanket for Germans to clutch as the social security net frays beneath them. Riester’s predecessor, Norbert Blum, frequently repeated that German pensions are safe, but demographics have imposed a starker reality on citizens. As the government weans workers from their dependence on a beneficent state, private pension providers are hoping greed will supercede fear in the investing public.
Paradoxically, the guarantee ensures that a hefty proportion of pension money that ought to be invested in stocks for growth will instead go into in bonds for safety. Quoting research from Frankfurt University and Goldman, Sachs & Co., Fidelity’s John says that Riester pensionholders will forgo anywhere from 1 to 3 percent of performance annually because of the inevitable overemphasis on bonds. As Deutsche’s Braeuninger observes, “We think the reform will need reforming.” The head of product development at one of Germany’s largest fund managers puts his disappointment more bluntly, “We were told by the government to build a Volkswagen when we could have delivered a Porsche.”
Still, Braeuninger is right when he points out that “this is a first step in the right direction toward a thorough restructuring of the old-age security system in Germany.” The Iron Chancellor, Otto von Bismarck, who built Germany’s social security system at the same time that he created the modern German state in the 1880s, once remarked that “Germans fear God and nothing else.”
Old age could prove to be the exception.
