Pension commitments - a viable alternative for the future!

In terms of capital set aside for pensions, direct commitments are the most dominant (and important) of the five company pension plan options in Germany. However, in recent years they have gradually become less relevant. This is due in large part to the complex administrative and financial requirements imposed on employers. Moreover, as the only option that affects the company’s balance sheet, direct commitments come with considerable risks. Luckily, a number of attractive alternatives are available.

Up until 1990, direct commitments accounted for 59.2% of capital set aside for pensions. By 2019, this figure had dropped to 47.7% (source: aba online). Because of the more difficult conditions mentioned above, employers are now increasingly choosing options that are easier to manage and which allow for the financial costs to be planned well in advance.

In short, a direct pension commitment is the “classic” company pension plan option. With this option, an employer makes a commitment to provide retirement/disability and/or death benefits directly to its employee. In other words, in the event of a pension claim, the employee is paid directly by his/her employer.

Employers are more or less free to configure direct commitments however they please. This is what makes the option so popular among employees with large pension plans, such as managing directors and executives.

Employees can choose to participate in their employer's pension plan by way of deferred compensation. Contributions of any amount can be made during the accumulation phase (e.g., in pension plan reinsurance) by both the employee and the employer, without any taxes whatsoever. In addition, as with other pension plan options, employees are not required to pay social security taxes.

By law, direct commitments must be reviewed regularly to verify the value of current pension benefits. Moreover, they are protected by the German Pension Insurance Association (Pensionssicherungs-Verein or “PSVaG”) against the insolvency of the employer. The employer pays contributions to the PSVaG for this purpose.

The employer must report the total amount of the promised pension benefits as pension liabilities in its commercial and tax balance sheets, as per all applicable regulations. During the accumulation phase, this can therefore have a negative impact on the company’s profits due to the increase in the liabilities. During the payout phase, this impact is reversed thanks to the gradual settling of the liabilities.

So much for the basics. But how does a company finance the direct commitments it makes to its employees? There are several ways to do it. Below, we'll look at the two most commonly used methods, as well as an attractive alternative.

The pension liabilities described above are merely an acknowledgment of the total pension commitment. They do not serve as a means of financing the subsequent pension.

When the employer pays the pension, the funds come from the company’s existing capital. The company therefore bears the following risks, which are in no way inconsequential:

• Employee longevity
• Liquidity risk
• Balance sheet risk

The employer must also pay all administrative expenses or outsource its pension management to a service provider for a fee.

With this type of financing, the employer takes out insurance policies as a means of financing its pension commitments. These serve to minimize (or ideally, exclude) the above-mentioned risks. The employer can choose between partial, “congruent,” or “quasi-congruent” reinsurance: In the case of partial reinsurance, only individual risks (e.g., occupational disability) are reinsured. In the case of “quasi-congruent” reinsurance, the entire commitment is reinsured, including anticipated shares of profits, whereas in the case of “congruent” reinsurance, the value of the initial commitment is reinsured.

The value of the reinsurance policies must be recorded on the assets side of the employer's balance sheet.

If a company opts for reinsurance, it should be noted that guaranteed maximum legal interest rates have been falling for years (2022 – 0.25%). Shares of profits are in fact added, but should not be taken into account when making calculations.

With this form of financing, the administration of funds (insurance), including collection and disbursement, as well as the payment of benefits, are often handled by the insurer. The employer enters into applicable service agreements with the insurer for this purpose.

A hitherto unknown but highly attractive form of financing direct commitments involves the use of securities. Currently, very few companies make use of this option. When combined with widely-used direct insurance, securities can help create an extremely modern and attractive pension plan.

Pension commitments with securities are a type of direct commitment. The amount of the pension commitment is determined by the value of the capital investment. In practice, the employer pays a certain amount for an investment product. The employee then receives the value of the investment product as a benefit, whatever that value happens to be at the time of their pension.

However, such an investment is considered part of a defined contribution plan and not permitted in the area of direct commitments. The pension commitment must therefore be structured in such a way that the employer guarantees a certain benefit (e.g., the full amount of the paid contributions).

Provided the value of the investment is not less than the guaranteed benefit, the company is not required to record actuarial gains or losses on its balance sheet. This eliminates the problem of steadily falling interest rates associated with traditional direct commitments.

Pension commitments with securities also have no impact on balance sheet ratios. As a rule, a pension liability does not have to be listed because the value of the investment is netted against the pension commitment. Solely the employer’s contributions are recorded in the profit and loss statement. Pension commitments are included in balance sheet notes for informational purposes only.

These pension commitments are often capital commitments. In such a case, the capital investment is liquidated and paid out to the employee receiving the pension. Nevertheless, pension payments and payout plans can be arranged between the company and the employee. If the employee wishes to receive a lifelong pension payment, the available capital is paid into a pension fund and the payments start immediately. In addition, pension commitments with securities become even more interesting when combined with direct insurance that covers the risk of occupational disability.

Conclusion

Pension commitments with securities are an attractive tool for replacing existing pension plans involving direct commitments. In particular, they help companies keep their pension-related financial and administrative risks to a minimum.

The adesso Group has recently met all the requirements necessary for providing companies with comprehensive support on pension commitments with securities. Our newest subsidiary, adesso benefit solutions GmbH, will be happy to advise you on such a project.

in|sure CollPhir, adesso insurance solutions GmbH’s new management tool, has been winning over customers since being launched on the market. With this tool, we help companies perform their own administrative tasks in a simple and effective manner.

Drawing from our comprehensive approach to consulting, we allow companies to review their pension schemes and develop modern pension plans for their employees. adesso insurance solutions is excited to contribute to the future expansion of pension commitments with securities.