Policy priorities for modernising our pension systems: The example of Germany
Societies are aging rapidly, and in the next few years large cohorts of "baby boomers" will retire. To give but one example: By 2038, the number of Germans over the age of 66 could grow by four million, according to projections of the German Federal Statistical Office. This will lead to significantly higher pension spending. At the same time, the number of people of prime working age (20-66 years) could fall by four million. In 2013, there were 30 elderly people for every 100 people of prime working age. Today, there are 32. By 2038, that number could jump to 44.
Figure 1. Germany’s old-age ratio is set to increase rapidly
Number of people aged 67 years and older per 100 people of prime working age
Source: German Federal Statistical Office
The long-term sustainability of pension systems urgently deserves more attention. There is a risk that public pay-as-you-go pension systems, on which pensioners in many European countries rely as their primary source of income, will either no longer be able to fill their traditional role, or that funding them will devour an ever-larger share of the state budget. Projections by the Organisation for Economic Development and Co-operation (OECD) suggest that in the coming decades, public finances in almost all EU countries will come under strain from higher spending on health and pension expenditure. Even today, around a quarter of the German federal budget is used to subsidise the statutory pension insurance system.
What's more, demographic change is not the only challenge we will have to overcome in the coming years. The Russian war of aggression against Ukraine and increasing geopolitical tensions symbolise a turning point in history that will demand a great deal not only of political systems, but also of our economies. Climate change and advancing digitalization require a profound economic and social transformation, which requires huge investments. The European Commission estimates that the EU needs to spend almost EUR 500 billion per year in order to achieve its emission reduction targets until 2030. If a growing share of the government budget is tied up in social security systems, it will be hard to support investments in digitization and decarbonization.
What can a sustainable pension system look like against this challenging backdrop? Policymakers should set two priorities: First, pension systems must be modernised and targeted relief provided. Second, economic policy must create the conditions for sustainable, long-term growth.
Pension systems must adapt to a new reality
The rapid aging of society presents the pay-as-you-go system with a choice between three evils: either employees' pension contributions rise sharply, the state spends an ever-larger share of the budget to stabilize the pension system, or the standard of living declines in old age.
What are the reform options? On average, Europeans are living longer and longer, and the physical demands of many occupations have changed. Accordingly, the regular retirement age should rise in line with life expectancy. For physically demanding occupations, retraining and continuing education opportunities should be created that enable a longer participation in working life. Another interesting option would be to abolish the mandatory retirement age and let people choose themselves for how long they would like to work. The resulting increases and reductions in pension entitlements would have to be calculated actuarially correctly, which is currently not the case.
Relying more on asset-backed pension plans is a second reform avenue. Funded schemes cannot replace established pay-as-you-go schemes. However, the respective advantages and disadvantages of the two systems complement each other well. Pay-as-you-go schemes protect against international economic upheavals and inflation, but they are vulnerable to demographic change and downturns in domestic labour markets: weak wage developments lead directly to weak growth in pension entitlements. By contrast, investing capital abroad can lead to relatively more volatile returns. However, it offers higher returns as it allows the citizens of slowly growing economies to participate in the momentum of faster-growing ones. Unfortunately for countries like Germany, it is late in the game to build up a capital stock big enough to cushion the sharply higher pension spending looming in the 2030s. Countries that are being discussed as role models today have already started investing capital on a large scale in the last century.
Given the urgency, we should pull all available levers. The state and the private sector, pay-as-you-go financing and capital funding can all make an important contribution. This includes the changes to pension insurance outlined above and a simultaneous build-up of capital stock, as well as renewed efforts to help citizens invest in voluntary pension schemes. In the latter area, Germany has witnessed a worrying development. Rather than increasing, the share of employees with state-subsidized private or occupational pensions has declined in recent years, from 71 per cent in 2011 to 66 per cent in 2019. Further modernisation of voluntary pension schemes will be needed to break this trend.
Figure 2. Supplementary pension schemes are becoming less widespread
Share of employees with supplementary pension schemes, %
Source: Kantar Public
A modern pension system also needs to consider the many different forms of work that have emerged in the last decades. The current system in Germany is predominantly tailored to employees who pay contributions continuously for decades and work for large companies that offer company pension plans. Today, however, people often switch between self-employment and salaried employment, or they are employed as platform workers not subject to social security contributions. In addition, there are many self-employed. All these groups are often inadequately covered under the current system. It is encouraging that the German government has announced its intention to overhaul the pension system for the self-employed. Low-income earners also need more support in building up pension entitlements. Looking at the corporate side, offering company pension plans needs to become more attractive for small and medium-sized enterprises.
Forward-looking economic policy can stabilise pension systems
Complementing the modernization of the pension system, forward-looking economic policy plays can both support the transformation of the economy and cushion demographic change. A stronger focus on retraining and adult learning can alleviate shortages of skilled workers and, as described above, ease the burden on the pension system. In countries like Germany, untapped potential lies in its part-time workers. Surveys show that only a quarter of them do not want a full-time job, and even a modest increase in their weekly working hours would make a notable difference. Business and government both need to do their part in activating the labour force, for example by providing better childcare, designing age-appropriate workplaces, and identifying the comparative strengths of older workers.
Improving framework conditions for employees can also help make a country more attractive to potential immigrants and thus counter the shortage of skilled workers. The path the German government has recently taken with its Skilled Workers Immigration Act is the right one: Immigration must become less bureaucratic and the recognition of foreign qualifications must be facilitated. In a next step, the consistent implementation of the improvements is crucial. In addition, Germany also has an emigration problem. In 2022, 7 per cent of the foreign population in Germany – 750 000 people – left the country. In the last twenty years, this share has never dropped below 6 per cent (Fig. 3). Lowering it would be very effective in addressing labour shortages and would preserve the human and physical capital already invested in the foreign nationals residing in Germany. More counselling, help with integration, and easier family reunification could increase immigrants’ willingness to stay, but soft factors such as societal appreciation also play a role.
Figure 3. Too many foreign nationals living in Germany are leaving
Foreign nationals leaving the country as share of foreign population living in Germany
Source: German Federal Statistical Office
Finally, government can also contribute to the sustainability of pension system by implementing reforms that promote economic dynamism. Some investments will be rendered worthless by decarbonization; some business models will no longer work in the digital world. To ensure that this does not paralyze the economy but rather leads to new growth, the government should make insolvency processes efficient, facilitate market access for new companies and open up financing opportunities via easier access to European capital markets. In some cases, industrial policy can help establish new key industries. However, we should not engage in a subsidy race with other countries. The government can put the money to better use by improving the framework conditions for private investment. Reforms with potentially enormous positive effects include, for example, the consistent simplification of planning procedures, the expansion of power grids and the expansion of the capacities of public administration. These measures would support the transformation of the economy and contribute to long-term growth in prosperity. Higher incomes in turn finance higher pensions and create budgetary space for supporting those in need.