Book reserves are still for a variety of reasons the dominant form of provisions for employers’ direct commitments. However, companies are increasingly moving their pension liabilities off-balance sheet to improve the structure of their balance sheets and to meet International Accounting Standards (US-GAAP, IAS).
We estimate that approximately 80% of asset-backed book reserves are funded through contractual trust arrangements (CTAs) off-balance sheet. The remaining 20% are covered by insurance policies or earmarked assets on balance sheets.
Especially in light of the declining equity market and the increasing uncertainty of equity returns in the near future, most companies are thinking about redesigning their pension schemes. Corporations would like to shift the investment risk towards their employees.
More and more corporations will no longer offer existing defined benefit (DB) pension schemes to their new employees. Instead, new entrants will be able to participate in the new defined contribution (DC) pension schemes.
The German government’s hope to boost occupational pension schemes through last year’s pension reform has not been proven yet. More than 50% of the total workforce (more than 16m employees) are covered through union agreements on newly introduced salary sacrifice pension schemes. The participation rate in these new pension schemes is still unpredictable. Nevertheless, we do not see a participation rate of more than 30% at most this year. This is mainly linked with the non-transparency of the new products and the heavy load of regulationfor them.
Despite widely discussed trends in favour of Pensionsfonds, we expect the book reserve funding volume to grow by 8–10% a year.
About €180 bn will flow into capital markets until 2010. Most of these assets will be invested into separate Spezialfonds to benefit from accounting and tax advantages.
The new Pensionsfonds in today’s structure are not able to replace the existing book reserve financed occupational pension schemes for a number of reasons:
o pensions in Pensionsfonds are limited due to a contribution cap of 4% pa (maximum €2,160), book reserve financed pensions are unlimited;
o DB schemes for higher-paid employees or management can lead to contributions to Pensionsfonds as well as on-balance sheet book reserves;
o due to the definition of the Pensionsfonds under insurance law (VAG) the investment policy is under heavy constraint despite the ‘prudent person’ principle;
o past experience shows that unconstrained portfolios are more efficient than portfolios under investments constraints;
o on-balance sheet financing keeps pension cash flow as part of the total liquidity management of the corporation whereby the pension cash flow for pension funds will be only defined by the asset liability management;
o the over-regulation of Pensionsfonds requires increased administration capabilities and increased cost load for Pensionsfonds products;
o taxable losses of the Pensionsfonds cannot be compensated for by corporate profits due to the life insurance character of the Pensionsfonds;
o due to the new tax law implemented in 2001, equity investments can outperform traditional reinsurance policies tax-wise.
As valuation examples by KPMG show, tax-optimised asset-backed financing can save up to 70% of total cost in comparison to traditional reinsurance financing.
As we have seen above, the traditional financing of occupational pension schemes through book reserves allowed German companies to finance their core businesses inexpensively. The book reserves were used as debt on-balance sheet.
As market environments and economic conditions change, companies in light of the ageing work force are exposed to future cash outflows. The increasing pensions payments will in certain companies impact their free cash flow substantially and will reduce the companies’ ability to meet their capital expenditure requirements.
The introduction of a CTA and the related partial separation of pension assets from the balance sheet and the focus on the companies’ core business will substantially improve the companies’ financial strength. The main advantages are:
o the CTA structure allows the company to invest the pension assets with higher long term return targets and reduce the overall costs of the pension plan;
o the off-balance sheet investing will reduce P&L volatility from investments and may result in more stable earnings flow that increase the companies’ valuation
o balance sheet contraction according to US-GAAP or IAS
o assets will be recognised as plan assets under the international accounting standards
o the German tax advantages of the book reserves are preserved (tax balance sheet remains unchanged)
A CTA may be founded as a registered association (eV), endowment or trust.
As the assets of the CTA are accepted as plan assets, short-term investment volatility should not impact the companies P&L. The company can act as a long-term investor and use all tools of modern asset management and portfolio construction to improve the return on assets.
The balance sheet will be shortened and respectively the capital structure of the company will change. This might give corporations more flexibility on financing their core business. To use capital markets as a source of capital, the restructured balance sheet will allow future investors to compare appropriate information and allocate capital more efficient to the company.
The tax balance sheet remains unchanged. The annual increase of the book reserve related to pension liabilities is a tax-deductible business expense. The external accrued excess returns on pension assets can be accumulated tax-free.
The employees pay taxes on the full amount of their benefits (§22 Nr. 5 EStG). Pensioners are not entitled to Altersversorgungs-Steuerfreibeträge. The new taxation regime of the pension reform will make it less advantageous to beneficiaries under Pensionsfonds.
Modern pension scheme financing implements a variety of modern techniques like asset-liability modelling, strategic asset allocation studies, portfolio construction and the whole universe of risk management.
The risk of the pension scheme is not to be able to meet the financial liability of the plan. In case of underfunding of DB plans, the sponsoring company is liable to cover the gap and pay additional contributions to the fund.
Before a Pensionsfonds can become an alternative to CTA/book reserve to finance DB pension schemes, there is still a long way to go. We need a second step of pension reform with substantial changes in the current structure and handling of the new vehicle.
Even if well-intentioned consumer protection driven regulation leads to in-transparency and non-acceptance by a broad majority of employees, something has to be changed. Instead of paying tax-financed subsidies into pensions products to make them attractive, the government should focus on changing legislation.
There is still a long to-do list to be worked on. We hope that the new government will pick up the pension topic shortly after elections and will make the second step towards pension reform.
Dirk Popielas is executive director, Pensions Services Group, with Goldman Sachs in Frankfurt

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