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|Underwriting the value of Riester-Rente: the German model of risk distribution in supplementary occupational pensions. By Csaba Burger and Gordon L Clark. Centre for Work, Employment and Finance, Oxford University Centre for the Environment, South Parks Rd., Oxford OX1 3QY|
The German pension reform of 2001 was a milestone on the road towards pension individualisation. It enhanced the funded occupational (and private) pension system (Riester-pensions), and therefore shifted investment risks to employers and individuals. The new occupational scheme allows for different types of pension vehicles that are either defined benefit (DB) or defined contribution (DC) plans. Since all such schemes are embedded in multiple layers of institutional insurance mechanisms, including strict investment principles, even the riskier DC schemes have limited exposure to financial market volatility.
This article explores the extent of risk individualisation in Riester-occupational pensions by describing risk distribution between the employee and the employer. It starts with discussing the relevant legislation since the nineteenth century until the reform of 2001. The reform defined two main risk-related decisions which are analysed here. The first, the selection of the pension vehicle, determines the scope of the risk. The second is the choice between DB and German DC that defines the distribution of risk between the employer and the employee. Finally, the paper investigates these choices empirically by using a unique, proprietary data-set of a German pension provider with approximately 271,000 pension scheme enrolees joining in the years between 2002 and 2008.
The findings highlight the employer’s pivotal role in determining the options available to the employee. For this reason, employee’s choice is limited and could partly be explained by socio-economic variables traditionally associated with risk aversion. Furthermore, despite the low level of risk embedded in Riester-type occupational pensions, individuals prefer the low risk alternatives. The study also identifies a conscious, risk prone group of employees who joined the savings plan right after the reform, in 2002 and 2003. Enrolees of the latter years are more likely to prefer insurance over uncertain returns, and reject the idea of risk individualisation.
Date: 05th January 2010
Number of words in the abstract: 299
Number of words, excluding abstract and annexes: 7829
The surging expenditures of public pension systems represent enormous challenges to the governments of ageing societies (Barr, 2006). Attempts to tackle such problems over the last two decades included the privatisation of pension provision and the transfer of responsibility for old age finances from the public to the individual (Gruber and Wise, 2007, Taylor-Gooby, 2004 and Börsch-Supan et.al., 2005). These moves inferred the retreat of the state from pension provision (Clark, 2000) and the rise of private welfare markets (Bode, 2007a). In other words, retirement decisions were individualised (Vickerstaff and Cox, 2001), including the selection of savings vehicles and its risk-return combinations. These processes certainly demonstrate a great variety over geographies (Dixon and Sorsa, 2009) with country-specific institutions offering pension products in a collectivist masque (Dixon, 2009); the inherent characteristics of such plans remain individualistic. ‘Self-made’ pensions are on the rise (Bode, 2007b). Since guaranteed pension benefits are a ‘hollow ideal’ (Clark, 2003), individuals have to reach decision over pension finances under the conditions of risk and uncertainty (Kahneman and Tversky, 1979, Clark, 2009).
International examples show a great variety of risk individualisation. In the UK, the Personal Accounts Delivery Authority (PADA) was created in the course of a pension reform to provide occupational pensions at low cost for low- and moderate earners who have less understanding of financial matters. This non-profit organisation offers employee-financed, defined contribution pensions on a voluntary basis. Most participants make no decision and receive therefore the ‘default’ fund option. There are a range of funds on offer for active plan participants. Some of them promise a clear risk-return relationship in financial terms, while others offer alternative interpretations of risk (e.g. ethical funds investing in companies that meet non-financial, value-based criteria, or ‘Sharia’ funds that comply with the requirements of Islamic finance). The investment risk is always borne by the employee (PADA, 2009). Another good example is Sweden, where the so-called ITP occupational pension scheme was reformed in 2007. The reform introduced an exclusively employer financed defined contribution scheme, where half of the pension savings has to be invested in traditional pension insurance. The investment of the other half can be determined by the employee. This system does not guarantee the ultimate level of pension either.
Germany is a special case in terms of pension risk individualisation. The pension reform of 2001 (so-called Riester-reform, named after the Minister of Labour, Walter Riester) eliminated a part of a safe and generous public pension provision. It introduced voluntary occupational and private funded schemes with state subsidies to offset the pension retrenchment. This was a fundamental change: a part of the publicly provided pensions was officially replaced by voluntary savings option with individual risk-return decisions (Schmähl, 2001). The importance of the employer decreased in the risk-related decisions, and a fair amount of responsibility was shifted to the employee (Berner 2008). Consequently, employers and employees have to reach two major risk-related decisions when enrolling in occupational pensions. The first choice is the selection of the investment vehicle (direct insurance, Pensionskasse, or pension fund), which determines the institutional setup and investment policies related to the pension savings. Although the product characteristics differ to some extent, they share a similarly robust insurance element. The second choice is on the nature of employee benefits (defined benefit (DB) or German defined contribution (German DC)). The employee receives an ex ante guaranteed positive return in the case of a DB pension, and a minimum return of zero in the case of the German DC plans. Individual risk is therefore limited by the collective risk-sharing mechanism of insurance.
The aim of this paper is to understand the structure of risk distribution between the employer and the employee; to investigate the possible extent of individual risk customisation, as well as to study the determinants of the risk-related employee decisions in the case of the German Riester-subsidized occupational pension products. First, the paper summarizes the development of risk distribution in occupational pension provision over the nineteenth and the twentieth century, and arrives at the last major pension reform of 2001. Since then, both private and occupational pensions have grown dynamically (Börsch-Supan et.al., 2008), with approximately nine million Riester-type occupational pension policies at the beginning of 2008 (Alterssicherungsbericht, 2008). Since these funded pension products rely on the performance of the financial markets, the crisis starting in 2008 underscores the importance of the legally defined risk distribution and the actual preferences between employer and employee.
To start with, the Riester-type employee-employer risk sharing will be presented in the historic perspective of the German occupational pension provision (section two). Further, the paper analyses the nature of risk among the institutions involved in occupational pension provision and the employee (section three). The last two parts of the paper investigate actual decisions under risk empirically. These sections rely on a comprehensive, proprietary database of a German occupational pension provider with over 271 thousand employee contracts. The starting dates of these contracts vary in time from 2002 to the end of 2008, offering an opportunity to scrutinize the pattern change of risk decisions in the years between two grave financial crises. The discussion of occupational pensions over the last century, the size of the database, the uniqueness of the timeframe, and the special setup of the German pension system make this paper a distinctive contribution to the literature of the German pension reform, pension individualisation and decision making under risk and uncertainty.