Ifo Viewpoint No. 16: A step in the right direction

Hans-Werner Sinn
Munich, 18 October 2000

New impetus in the pension reform debate has come from the study presented in 1998 by the Scientific Advisory Council of the Ministry of Economics. The years of denying the demographic problems are now finally over. Germans have fewer children than they once had, so few that pension insurance will drift into crisis if nothing is done.

The looming crisis can only be avoided by reducing future benefits and by investing the money that was not spent on child rearing in the capital market in order to secure future pensions since we cannot expect this from the fewer children we have.

As proposed by the Council, the government is recommending an annual capital investment of 4%, a level which is not to be reached by 2008, however. At the same time, the increase in pensions benefits will be reduced. Benefits will be increasingly lowered for both old and new retirees over the course of time since the recommended capital formation will reduce the basis of assessment for calculating benefits. In addition, new retirees will experience special reductions vis-à-vis the older retirees.

The improved situation of the older retirees is welcome in keeping with the sense of justice between generations since those who retire before 2011 are still part of the generations that raised comparatively more children and who have not caused the pension problem. That the following generations should receive gradually lower benefits is logical since they have also gradually accounted for fewer children (Sinn and Werding, Schnelldienst 18/2000). It is also right that pensions should be differentiated according to the individual number of children. The socialisation of the pension contribution of one's own children, that was enforced by the old pension insurance system, will thus be eliminated. In future, both the funded as well as the pay-as-you-go portion of pensions will depend on how much one has contributed to the financing of these pensions.

A somewhat disturbing aspect of the reform concept is the redefinition of net wages by the deduction of the recommended capital formation. This redefinition optically increases the "pension level" - which will only be 62% of net wages in 2030 - to the target level of 64%. Another fault is that the government still operates with a set of very favourable assumptions that give the impression that the contribution rate will only rise to 22% by 2030. According to calculations of the Ifo Institute, the rate in this year would be 23%, and by 2035 an increase in the contribution rate to 24% must be expected. If the recommended capital formation is factored in, the total burden adds up to 28%. This is the figure that would result without the reform and that politicians have wanted to avoid. The proposal of the Scientific Council to start earlier with a higher savings rate and to reduce this rate in the crisis years deserves just as much attention as the recommendation of the Ifo Institute, based on generational balances, that the contribution rate be locked at 20% and that even farther-reaching cuts in the pay-as-you-go benefits be accepted.

Apart from this, the reform proposal is a step in the right direction and a good basis for a compromise with the hopefully bolder demands of the opposition.

Time is short. A structural majority still exists for a reduction in benefits, but this majority will shrink each year. Once the pension crisis has truly begun, it will be too late for reforms since the majority of voters will be among the losers of such reforms. Then the pension system will topple, and with it perhaps the country as a whole.

Hans-Werner Sinn
President of the Ifo Institute