Rates of Return of the German Pay-as-you-go System

Population ageing exerts great pressures on the German public pay-as-you-go (PAYG) pension system. On the one hand, expenditures rise as pensions have to be financed for longer periods due to continuous increases in life expectancy. On the other hand, revenues stay behind as working cohorts become smaller due to low fertility rates. The current situation will deteriorate further once the baby boom generation will begin to retire around 2015. As a consequence, if retirement ages cannot be raised sufficiently, either contribution rates must rise or pension levels must decrease in the long-run.

In the past, the German pension insurance recorded comparably high pension levels (70% of net wages). These were maintained until the end of the 1990s causing substantial increases in the contribution rate. The two latest pension reforms in 2001 and 2004 limited future increases in the contribution rate by allowing a reduction in future pension levels. The past and future development of contribution rates and pension levels relative to gross wages is depicted in Figure 1.

Rates of return of future pensioner cohorts thus will deteriorate due to rising contribution rates and declining pension levels. In Germany, the size of the individual pension is proportionally linked to the amount of contributions during the working life. In this earning points based sys-tem, a rise in the contribution rate leads to an increase in the price of earning points such that higher contribution payments have to be made. Cohorts that are affected by this therefore have to pay a larger share of their wage for one earning point than earlier working cohorts. Absolute equivalence of contributions between cohorts is therefore not given, which is why rates of re-turn differ among cohorts. However, within one cohort a rise in the contribution rate affects all working individuals equally. In summer 2004, this issue triggered a public discussion when the chair of the Federal Consti-tutional Court, Hans-Jürgen Papier, made an official statement that the constitutional confor-mity of the German public pension system would be threatened should future rates of return become negative for entire cohorts. The question of how high future rates of return are going to be is very closely linked to that of the appropriate calculation method.

Both questions are addressed in this project. In addition to the standard scenario-based ap-proach that frequently is used in the German pension literature, an alternative stochastic ap-proach is proposed. Rates of return calculations based on both concepts show that cohort-specific rates of return of the German public pension system will decline in the future but re-main positive. (see table) This can be shown for nominal as for real rates of return. While the decline in the rates of return of the German public pension system represents an int-ergenerational redistribution, one should keep in mind that this redistribution would have been larger without the latest pension reforms. Moreover, this finding alone should not be inter-preted as an “intergenerational unfair” situation as the notion of intergenerational fairness re-quires a much broader view not discussed in this paper.

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