A British Model for Germany's Pension Reforms?

How much should workers rely on private retirement provisions versus those provided by the state? Or, put differently, how much of a worker's retirement income should come from a national pension scheme as opposed to a privately held retirement or company-based policy?

The governments of Germany and Britain -- like in many other policy areas -- have traditionally responded differently to these fundamental questions. But with the German system facing potential collapse under the weight of demographic pressures and economic troubles, should government leaders look to the British model for solutions?

Germany and Britain, the key differences

Germany and Britain have served as archetypes of the different pension systems in Europe. For more than a hundred years, the so-called "contract between the generations" has prevailed in Germany: the pension benefits of the retiring generation are financed by the contributions of the current working generation. Just one retirement plan is legally mandated, and the benefits paid out to individual workers is related to the amount that a worker contributed over a lifetime.

Therefore, retirement benefits are meant to maintain the standard of living attained during a lifetime of unemployment. If you earned more (and, therefore, contributed more) you'll get more, and vice versa. The system works as long as society's demographics play along with it. But when birth rates decline, people start living longer and unemployment figures rise, there aren't enough people paying into the system to counteract those taking out.

As a result, some people have suggested replacing the current German system with a "basic pension" ("Basisrente"), which would see all pensioners receive the same amount, regardless of previous income. That would mean that in order to maintain their standard of living, millions of German's would have to pay into private pension plans.

Though this idea might be anathema to many Germans, it has long been the norm in Great Britain. There, the "basic pension," administrated and paid out by the government, provides for basic needs, but nothing more. It by no means ensures that a worker will be able to maintain his or her previous standard of living. That's why, in 1978, a legally required additional pension, came into being, the State Earnings Related Pensions Scheme (SERPS).

Many who relied solely on the basic pension system -- and didn't have personal or company plans -- were falling through the cracks, and SERPS was meant to serve as a safety net, essentially making sure that every working person had some form of pension in addition to the basic state pension. SERPS benefits are related to previous income: those who earn more pay higher contributions -- but they also receive higher benefits. What's more, SERPS is also based on the pay-as-you go model, with current contributions covering current payments and the government makes up the difference.

Motivating people to make invest privately

Workers in Britain can opt out of the legally required SERPS pension scheme if they make other comparable private arrangements or have a pension scheme through their employer (the majority opt out to take advantage of employer-offered schemes). If a British worker chooses to opt out of the SERPS program, then his or her social benefit contributions are reduced. And because its in the interest of the state to encourage as many people as possible to take out private pension plans or go with one offered by an employer, the government offers tax incentives to those who do so.

By pursuing this course of action, the British government hopes to encourage individuals to take on the responsibility of providing for their own retirement. Basically, the British government is looking to get out of the pension provision business. The state-controlled pension system, which is funded by social benefit contributions, will eventually be unburdened by an alternative system of private and company benefit schemes, which are financed by accumulated capital. And the government is well on its way to making this state of affairs a reality: 86 percent of men and 77 percent of women have opted out of the government run SERPS program and made alternative (private) arrangements.

The private and company-based pension schemes are largely administrated by trustees, who invest the money in stocks and bonds. So in addition to removing the burden of providing for retirement benefits from the state, this way of doing things also funnels large sums of money into the market. That can certainly do wonders for a country's economy.

A new model for Germany?

Would such a system also work in Germany? The answer is complicated. With the downturn of international stock markets, many of the funds lost value. Many who had hoped to shore-up their state benefits with other arrangements -- and thereby enjoy a comfortable retirement -- saw their private pension funds drop by as much as 20 percent. So, while this way of doing things might unburden the system and energize the stock market, it comes along with a certain amount of uncertainty, and has bred a bit of mistrust in the system. What's more, the power of the trustees, who control millions in investment capital generated by the contributions, is thought by some critics to be too much.

Demographic pressures

Ultimately, the British pension system suffers from the same pressures as the German one: a demographic problem (an aging population and low birth rates) and a sluggish economy. There are more people retiring than entering the work force, and the contributions of the working generation simply no longer covers the costs of financing the retiring generation.

In order for a plan such as the British one to work, it would have to effectively counteract this problem. But, the private and company-based funds, just like the statutory German fund, are also subject to these pressures. So the British model, while having certain benefits over the German model, is not an end-all solution.

What's more, it might not be so easy for the German government to embrace privatisation and get out of the pension business, so to speak. British citizens, through generations of experience, are more accustomed to taking on some of the responsibility and have gradually come to accept they'll have to manage some of the risk on their own. In Germany, however, people have become accustomed to leaving things in the hands of the government, and it could prove very difficult to change this way of thinking -- unless would-be reformers can point to significant advantages.