Germany prepares for DC era

In early January, an order to management of IBM's German arm from the firm's New York headquarters may have gone something like this: "We are slashing pension costs worldwide. Place all German employees on a defined contribution (DC) scheme."

Johann Weihen, chief executive of IBM Deutschland, knew how serious the top management of the computer giant was. It had just frozen the defined benefits (DB) pension plan for its US employees and had already began the process of trying to place all UK employees in a DC scheme.

IBM Deutschland's management figured that by switching the half of its 22,000 employees still on DB schemes to its DC one, it could cut its pensions costs by several hundred million euros. But there was a problem: Since workers in Germany have a say in corporate decision-making, the full embrace of DC had to be approved by employee representatives at IBM Deutschland.

That approval never came and in July, the firm's frustrated management was forced to abandon the switch to DC. It seems that the management may have forgotten German pensions law in its eagerness to please New York. (IBM Deutschland has declined to comment for this article). The employee representatives, on the other hand, knew their rejection of the move was on solid legal ground, except in special cases like insolvency,

German pension law makes it nearly impossible to change standing pension plans when the outcome means cuts in benefits.

IBM's recent failure is, however, in no way indicative of DC's fortunes in Germany. Quite the contrary, because DC transfers the risks associated with future pension benefits from employer to employee, the concept is catching fire in corporate Germany. Numerous firms have either introduced them alongside existing DB ones - thereby avoiding any labour or legal trouble - or as their first pension plan.

DC plans in Germany were also given a boost by the 2002 enactment of the so-called Riester reforms. The reforms gave employees a legal right to contribute to a DC scheme which would either complement existing pension plans or serve as the initial one. As a result, many smaller German firms have introduced DC schemes for the first time and in some cases a top-off to the employer contribution is provided. And contributions up to 8% of salary are not only tax-deferred but free of social tax, though the government is considering terminating the social tax exemption from 2009.

Yet as DC accounts for roughly a quarter of all German pension plans, with the rest DB, pension experts believe that the concept's initial popularity is just the tip of the iceberg. For example, Marc Oliver Heine of Watson Wyatt's Munich office believes that Germany will see a boom in DC similar to the one that has taken place in the UK. In a new study, Watson Wyatt found that DC now accounts for 62% of all UK pension plans - almost four times as much as in 1998. Meanwhile, the share of DB has sank to 33% from 71% in 1998. With respect to Germany, Heine, a senior consultant, says: "I don't have any empirical data, but I would say that of all the firms which currently offer DB, 80-90% are thinking about implementing DC. To me, that is evidence of an imminent boom."

Adds Boy-Jürgen Andresen, chief executive of German pensions consultant Heissmann: "Apart from perhaps those for top management, all new pension plans that we're seeing in Germany involve DC-oriented models instead of classic DB schemes."

While reducing pension cost was an important factor in IBM Deutschland's case, the experts say demand for DC among German firms is being chiefly driven by the need to minimise pension risks - like the fact that retirees are living longer.

Indeed, Heine notes that owing to German pensions law, companies that want to fully switch from DB to DC must maintain previously agreed benefits. "DC can even be more attractive to employees as, unlike with DB, there are no limits to the benefits that can be achieved through contributions and return." To recall: DB plans provide a fixed pension until death based on an employee's previous salary.

On the other hand, DC plans can be far less costly to employers than DB ones when, for example, contributions from employers are minimal or even zero or when the schemes simply mimic retirement savings accounts.

But Heine and the other experts stress that a bare bones DC scheme costing employers next to nothing is extremely rare in Germany. Another key difference, according to them, is that German employers guarantee paid-in savings to the schemes - utterly unthinkable for some US companies. Heine adds that DC schemes can also be crafted so that they pay a pension until death and so that spouses and next-of-kin can draw any remaining benefits.

In switching to DC, employers typically phase in the schemes by applying them to new hires. Prominent examples are the schemes at German automakers DaimlerChrysler and BMW, steel giant ThyssenKrupp and engineering firm MAN. And let's not forget IBM Deutschland, which has half of its employees on its six-year-old DC scheme.

By not threatening to cut accrued pension benefits, other firms like the German arm of UK mobile phone giant Vodafone have also succeeded where IBM Deutschland failed. Since June 1, all 9,300 employees at Vodafone Deutschland have been placed on a DC plan that is being administered by Watson Wyatt.

Under the plan, contributions from the employees and Vodafone go to the firm's external pension fund, and the assets are then invested according to a life cycle model. Simply put, the investment model involves overweighting equities when the employee is young and than gradually building up the fixed income exposure as the employee nears retirement. Prior to the full embrace of DC, the pension fund for Vodafone Deutschland - a contractual trust arrangement - had €264.7bn in assets, 63% of which were invested in bonds and 29% in equities. The remaining portion went to alternative asset classes.

From the vantage point of employers, DC plans definitely have big advantages both in terms of minimising the risks and the complexity of pensions. And if the employer offers a generous plan, DC can mean an excellent pension for employees.

On the other hand, the experts say German employers should not assume that DC is necessarily superior to DB. "While (with DC) the investment risk is passed onto the employee, an employer in Germany may be confronted with new risks, namely those associated with choosing the right investment plans and giving employees adequate advice," says Klaus Stiefermann, , managing director of German corporate pensions association Aba.

Stiefermann's point was echoed by Boy-Jürgen Andresen, chief executive of German pensions consultant Heissmann, who said: "In the US, where DC dominates, there have been many cases of employees suing employers when their DC plans have failed to meet their expectations."

"In view of our experience with strict, employee-friendly German labour courts, there is a risk that a situation like that in the US could arise," added Andresen, who is also Aba's current chairman.

Beyond the possible risks associated with DC, Andresen also points out two distinct advantages that DB schemes have. The first one is certainty about the level of pension benefit for both employer and employee. The second is what he calls a "contribution holiday", or the absence of a standing requirement on the employer to contribute to the plan.

DC is, nonetheless, on the march in Germany, as the examples of IBM, Vodafone and the new schemes at Germany's best-known companies show. And the pension experts stress that with the exception of smaller companies with less means, the new DC plans in Germany will not necessarily be less attractive than the DB plans.

Remarks Stiefermann: "What we're seeing is the birth of German DC. Employers choosing this method of retirement provision are not saying: ‘OK, here's the plan now you contribute and don't bother us'. No, the employers are participating, whether in terms of providing top-offs or the guarantee."

According to him, the main reason why German employers are, even in switching to DC, are trying to provide an attractive plan stems from the need to hire and retain qualified people.

"Another reason is political. German employers realise that they must do more to compensate for the shrinking state pension. Otherwise, social-minded politicians might start calling for a better state pension, which of course would mean higher costs to employers who pay part of the statutory contribution," adds Stiefermann, who is also a board member of the European Federation for Retirement Provision.