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The Victory of Hope over Angst? Funding, Asset Allocation, and Risk-Taking in German Public Sector Pension Reform

Day 1, March 22, 2007

Session II - Institutional design of the pension system

14.30 - 15.30 Lecture II.1 Raimond Maurer (Goethe-Universität)

Co-authored by Olivia Mitchell and Ralph Rogalla

Introduction and Motivation

Pension systems in much of the developed world have traditionally been of the "pay-as-you-go" (PAYGO) variety, in which retiree benefits are paid out of taxes (contributions) levied on the working generation. But rapid population aging and economic recessions now confront these PAYGO plans with severe financing problems. In particular, as the number of retirees rises rela-tive to the working age group that pays for these benefits, these systems are facing financial in-solvency. In some countries, Germany among them, this trend is intensified by high rates of un-employment, which lead to an even further deterioration of the contribution base. In the long run, these systems will require either reducing benefits if contributions are to be held constant, or increasing contributions if benefits are to be maintained. Both approaches make these systems much less attractive than in the past.

An alternative solution, much discussed in the Western world, would be to move these systems toward a funded position. Thus during the accumulation phase, contributions are paid into some form of account owned either by individuals or by the plan sponsor (e.g. the employer). These funds are then invested in the capital markets and the accounts grow commensurately with in-vestment performance. During the decumulation phase, after retirement, the funds assets are used to finance the benefits. One attraction of a funded pension plan is that it is better protected against population aging, though of course they remain vulnerable to adverse capital market per-formance. Depending on the plan's design, this investment risk is borne either by the plan spon-sor (in case of defined benefit plans) or the plan participant (in case of defined contribution plans).

Funded pension plans for civil servants are widespread in the United States, but in Germany, most civil servants have been promised an unfunded, non-contributory, tax-sponsored defined benefit pension after retirement. Politicians and employees have gradually become aware of the need to consolidate public spending, particularly in light of population aging, and small changes have begun to be implemented. In 1996, for instance, the state of Rhineland-Palatinate launched a financing fund to cope with the increasing burden of future pension payments. Currently, the annual endowment of this fund amounts to 20 to 30% of the state's current payroll. By law, no doubt because of extreme risk aversion among politicians, the fund's investment universe has been restricted to government bonds, thereby neglecting the opportunity to improve the perform-ance of the plan assets by investing partly in the equity markets. Accordingly, some first steps toward funding German civil servants pensions have been taken, but the system is still far from being a fully funded system and investment patterns remain extraordinarily conservative.

Objectives

As government budgets come under increased financial pressure, it is clear that it will become increasingly important to enhance the performance of plan assets and reduce the costs of defined benefit civil servant pension systems. Of course, the transition path will be accompanied by addi-tional payments required to build up the capital assets in the funded pension plan. Our study will evaluate the potential time path and size of these costs, focusing only on currently active civil servants. In particular, we will develop a model of financing and an investment strategy based on the specific liability structure of the pension system for the German federal state of Hesse. The analysis will assess the impact of introducing a supplementary tax-sponsored pension fund, whose proceeds are invested in the capital market and used to relieve the state budget from (parts of) the pension payments. Our evaluation model will determine the expectation and the Value-at-Risk of the economic costs using a stochastic simulation for pension plan assets. This approach simultaneously determines the optimal contribution rate and asset allocation that minimizes the expected economic costs of providing the promised pensions while at the same time controlling investment risk.

Our objective is to propose answers to the following key questions:

1)         What is the optimal contribution rate to a defined benefit pension fund for civil servants, which minimizes the overall costs for providing promised pensions?

2)         What is the optimal asset allocation for the fund as it is built up? Into which assets should the funds be invested to generate a maximum return while simultaneously restricting risk with regard to capital market fluctuations and the unique structure of liabilities induced by the pension claims?

3)         What are the best ways to control cash-flow shortfall risk to mitigate the potential burden borne by future generations of taxpayers?

This project will provide interesting implications for several groups. In the first instance, the re-sults of this study will be of major relevance for state and Federal Governments throughout Europe, as many employ a significant number of civil servants and face considerable pension liabilities. Moreover, the findings will be of interest to a wide range of researchers and govern-ments in North America and Asia, as regulators and supervisors everywhere seek to contain the explosive costs of civil servant pensions in an aging world.

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