July 2009

EDHED RESEARCH: don't panic, it's Germanic!

Contimuing our short series on pension fund regulation in some of the most important markets in Europe, Samuel Sender, of Edhec, looks at Germany...

brandenburger_tor.jpgGermany has relatively stiff regulation with valuation principles aligned with Solvency I. Traditional German occupational benefits have been provided through book reserve systems – ie, where reserves or provisions for occupational pension plan benefits are on a company’s balance sheet. Some assets may be held in separate accounts for the purpose of financing benefits, but these are not legally or contractually pension plan assets. In other words, machinery and investments may be financed out of pension liabilities.

This system is accompanied by a pension insurance scheme, the PSVaG, operated like a mutual insurance company. Upon bankruptcy of the sponsor, it purchases annuities from a consortium of life insurance companies. This traditional book-value reserving system has been praised for its contribution to financing the investment of businesses and at the same time guaranteeing the payment of benefits in the event of sponsor bankruptcy.

German firms, of course, must accrue pension liabilities in their local and international statements, but tax-deduction of unfunded accruals is allowed whether pension liabilities are set aside in a separate vehicle or kept on balance sheet.
Historically, then, German employers were neither compelled nor given tax incentives to build up external pension funds, a situation again radically different from that in other European countries.

Contractual Trust Agreements
Contractual Trust Agreements (CTAs) are external pools of assets, treated as such by IAS 19 but considered book reserves by
the regulator.

The regulatory landscape changed in the 1990s under the influence of large companies that desired IFRS-compliant and tax-effective funding vehicles.

Book-reserve pension plans are sub-optimal under international accounting standards. Keeping assets on the balance sheet leads to much higher volatility in P&L than having externalised assets and funded pension liabilities, as accounting standards permit
no smoothing.

CTAs were created by the private sector to allow earmarking assets for accounting purposes, and they were recognised under German tax law as on-balance sheet items available for book-reserve pension plans. CTAs are therefore recognised as funding vehicles for accounting purposes only, but, unlike ‘pensionskassen’ and ‘pensionsfonds’, they are not regulated as real external pension funds.

Most Dax30 companies have adopted this accounting scheme, for an average funding ratio of between 60% and 65%.

For book-reserved pension plans and CTAs, tax deduction for funding (to the balance sheet or externally), is based on a discount rate of 6% and makes no allowances for future salary and pension increases.

This contrasts with the IFRS calculation, which uses an AA yield for discounting (lower than 6%) and the projected measure (higher end benefits). Overall, it turned out that tax-deductible contributions were much lower than the cost of providing pensions under IAS 19. Companies that had followed the tax code to establish contributions often reported underfunded pension liabilities.

Pensionsfonds were created in 2002 on the accounting model of insurance companies, but in accordance with the Iorp directive. German Pensionsfonds are regulated legal entities separated from the sponsoring employer and offering direct entitlements to lifelong pensions. The sponsor may provide guarantees to the employees or have pension funds (partly) responsible for them: the sponsor remains the first line of defence if the contributions it has made are not paid out.

The discount rate used both for financial and tax statements is 2.25%. It is much lower than the 6% rate applied to CTAs, and contributions are more tax efficient. However, the low discount rate puts technical provisions for guaranteed benefits on the high side of the European range.

Pensionsfonds are regulated by the German Act on the Supervision of Insurance Undertakings (Insurance Supervision Act – VAG), even though they are different from insurance companies.

They must offer lifelong retirement benefits (with an allowance for 30% of the accumulated savings paid out as a lump sum at retirement).

Pensionsfonds offer a great degree of freedom in investment matters. Bound solely by the ‘prudent man’ rule, not by quantitative restrictions, they are free to determine their investment strategies.

Though they must be fully funded, a temporary 5% lack of funding is tolerated.

Valuation of assets
Bonds receive a typical Solvency I ‘asymmetric book value’ treatment. Unrealised gains can be accounted for at the discretion of the pension vehicle, but unrealised losses are not accounted for.

For equities (and other risky assets), unrealised capital gains increase the funding ratio – in Germany the regulator cannot oppose the decision to take these gains into account. Unrealised losses on equities require additional reserves, a form of market value adjustment. To put it simply, equities are, in essence, accounted for at market value.

The discount rate used for pension funds is implemented as follows: the technical rate for discounting guarantees is equal to 60% of the ten-year average eight-to-ten-year bond yield, 2.25% from 2007 onwards.

Unique in Europe is the low discount rate for technical provisions when the sponsor remains the first line of defence.

Premiums to pensionskassen, insurance companies specialised in providing retirement, are tax-deductible. As insurance companies, pensionskassen are subject to insurance regulation. Pensionskassen provide one part of the benefits in the form of interest rate guarantees and another in the form of conditional profit sharing.

As assets are subject to quantitative restrictions, and as underfunding would mean going out of business, pensionskassen are highly averse to risk and have little equity exposure.

Unlike pensionsfonds, pensionskassen liabilities are not covered by the PSVaG insurance scheme. Nor can pensionskassen rely implicitly on future sponsor and employee support by issuing contracts of the revisable premiums sort.

The evolution of the accounting and funding requirements for pensionsfunds is unresolved.

Summary of regulatory constraints on the ALM of German pension funds:
  • The asymmetric treatment of bonds is an incentive to have a net short ALM interest-rate sensitivity.
  • The funding ratio is overestimated when interest rates fall, and underestimated when market rates rise. Even when considering that unrealised losses on fixed-income instruments require an asset and liability adequacy assessment, there are incentives to build fixed-income portfolios that have a shorter duration than that of (annuity-like) liabilities.
  • If a five-year bond backs a ten-year annuity the pension fund is protected from any change in market conditions. If market yields rise and unrealised losses appear in the bond portfolio, the pension fund can argue that its economic solvency has strengthened, because the market-consistent value of the liabilities – which are of longer duration – has fallen more than that of the assets backing them. If market yields fall, unrealised gains appear and the regulatory funding ratio increases because the liability value remains unchanged. In reality, of course, the situation of the pension fund deteriorates.

• Samuel Sender is applied research manager with the Edhec Risk and Asset Management Research Centre. This article was based on research carried out within the EDHEC/AXA Investment Managers Regulation and Institutional Investment research chair

©2009 funds europe