German pension reform push crystallises challenges faced by many European countries

Ageing populations in the European Union and the pressure they are putting on pension systems are leading a number of countries to look at reform. The Netherlands is implementing a major reform, while France passed a substantial reform in 2023. Germany’s government is also moving forward with a reform package, though this is being held up by budgetary tensions.

The German public pension system is an earnings-related pay-as-you-go (PAYG) system, as in many European countries, meaning that the contributions of current workers finance the incomes of current pensioners. The German system is particularly large, but the challenges it faces are common to all PAYG systems. The ratio of the elderly (aged 65+) to the working-age population (20-64) in Germany is projected to increase from 37.3% in 2022 to 49.8% in 2050. In other words, by 2050 there will be almost one pensioner for each two workers in Germany, and the ratio is projected to rise even further after that.

The current net pension level of 48% of the average wage in Germany (for an illustrative standard career, before taxation) is projected to fall gradually to 44.9% by 2040. This is because of a ‘sustainability factor’ introduced into the German system in a previous reform, which limits the pension level if the number of pensioners grows faster than the number of contributors. The sustainability factor is important because it links the pension level to demographics in an effort to ensure financial sustainability of the system.

But the new reform package would guarantee to keep the level at 48% until 2039. This minimum pension level in the reform package works against the sustainability factor. Instead, contributions will be increased, putting more of the burden on labour and on younger generations. 

The burden will however be offset to some degree by a new investment fund, to be managed by a public foundation, and endowed by the government with an initial €12 billion in 2024, financed by government debt. Thereafter, the public contribution to the fund would increase by 3% each year. The government also plans to transfer an additional €15 billion of other assets to the fund in the period up to 2028. The expected value of the fund will be over €200 billion in the mid-2030s.

From 2036, the fund would disburse €10 billion annually on average to help finance pension expenditure and soften the rising contribution rate. The contribution rate would rise from 18.6% of gross salaries currently to 22.3% in 2045 with the fund, or to 22.7% without the fund.

The proposed investment fund was hailed as a “paradigm shift” by German finance minister Christian Linder when he proposed it in March. But it is not a capitalised pension pillar; rather, it would be funded by government debt instead of pension contributions. Furthermore, the governance structure of the fund, which will be crucial to its success, remains unclear. It must ensure that the proceeds of the fund are used only for pensions, and that the fund is shielded against any political interference. Furthermore, the fund is projected to offset increases in contribution rates by only a small margin. Discussions on these issues are holding up the German reform.

Diversifying the sources of income for a large PAYG scheme faced with an ageing population is a good idea. However, Germany’s proposed reform would be clearly to the cost of younger generations. The burden of reform should be shared across generations, even if it is politically difficult.

The current reform proposal is far from a comprehensive shift in financing. It creates an extra-budgetary item that invests government debt. Instead, the government should look to other options, such as expanding coverage of the mandatory pension scheme to include all self-employed workers. Currently, it is not mandatory for most self-employed workers to participate in the system.

The German pension system would also benefit from more occupational pensions. A true capitalised pension pillar, even if small initially, would expose households to the potential risks and benefits of financial markets while reducing reliance on the government budget. The same holds for other primarily PAYG schemes in Europe.

The government should also aim to activate household savings by giving life to a tame private pensions market that has failed to take off because of high costs to savers. German households hold 42% of their assets in cash and deposits, far more than in France, the Netherlands or the United States. In the long-term, GDP must be high enough to ensure that the needs of retirees and workers can be met. Funded pensions can activate savings to finance real investment and support long-term growth to ultimately satisfy these future needs. Germany’s current reform proposal, unfortunately, would not anchor funded pensions in the system.