The proposal for an equity reserve will not solve the challenge of making pensions sustainable.
Last month, the German finance minister, Christian Lindner, announced a major reform of the German pension system. He proposes to augment ‘pay as you go’ with a large sovereign-wealth fund invested in equities, bonds and commodities, whose returns would support the pension system. Faced with a rapidly ageing society, Lindner essentially seeks to relax the intergenerational contract, where an increasingly stretched workforce pays for pensions, and instead leverage the potential of equity markets.
Given financial markets can yield high nominal returns, many will find the suggestion from the leader of Germany’s Free Democratic Party intriguing. The proposal however appears to ignore the economic logic that, in the face of an ageing population, the only way to maintain current benefits without increasing contributions is to increase national output.
Workers shrinking
In Germany’s system, the working-age population pays for current pensions. The number of workers is however shrinking relative to pensioners, making the system increasingly expensive: in 1991 there were four workers per pensioner, in 2020 under three and by 2030 there will be under two. Unwilling to cut pensions or raise contributions, in 2021 the government provided taxpayer subsidies for pensions of around €100 billion, or 30 per cent of total pension spending—a figure which will grow as the population ages.
Seeking to alleviate this massive commitment, Lindner first sought to introduce an Aktienrente (equity pension), where workers build up individual funds over their working lives, as in the United States, for example. After that idea was scrapped in talks with his party’s social-democrat and green coalition partners, he seems to have been successful with a toned-down version, an Aktienrücklage (equity reserve), in which the returns on the fund’s holdings of financial and other assets substantially reduce the financing gap.
Financed by borrowing, the fund would be built up over 15 years, with an initial €10 billion from the 2023 budget. It would be publicly managed, probably under the remit of the Finance Ministry, but protected by strict rules from government interference.
Not much help
The fund is to be modelled on the German nuclear-waste disposal fund, KENFO, which aims to produce long-term yields of 4.3 per cent. If we assume that German government borrowing costs stay at 2 per cent, the equity reserve would yield an annual net return of 2.3 per cent.
Under those assumptions, the €150 billion reserve Lindner envisages would have a long-term annual average yield of €3.45 billion, or just 3.45 per cent of the current pension financing gap. To close the entire €100 billion gap would require a fund of around €4.35 trillion—much larger than any sovereign-wealth fund in the world. Even on the sensible assumption that its long-term rates of return would exceed government borrowing costs, the fund would thus not help much.
Consider the basic economics of pensions. Pensioners are not interested in money—coloured bits of paper with portraits of national heroes—but in consumption: food, heating, presents for their grandchildren and so on. Leaving aside the unrealistic option of physically storing goods and services for future consumption like a squirrel during one’s working years, the only way that people can continue to consume after retiring is by consuming goods and services produced by the working population. Thus what matters is national output and not the nominal size of accumulated claims on consumption.
Productivity and workforce
Suppose that a hypothetical workforce of 100 retires and, because of declining birth rates, is succeeded by a workforce of 50. If the 50 are no more productive than their predecessors, contributions will have to be doubled or pensions halved, or some admixture. So the test of any reform is whether it increases national output. Policies doing so typically raise the productivity of each worker by investing in more and better physical capital (say robots) and in their ‘human capital’ (education and training) and/or increase the size of the workforce by raising the retirement age, adding more women and fostering immigration.
Thus the central question about the Lindner proposal is whether it increases productivity or the workforce. The answer appears to be positive if the fund leads to a net increase in productive investment by improving firms’ access to capital—a big ‘if’, though, given Germany’s well-functioning financial markets and the fact the fund is supposed to invest in publicly traded assets.
And that answer needs to be tempered in a country such as Germany, because debt-financed investments in equity markets risk crowding out productive public investment, given that the Schuldenbremse (debt brake) enshrined in the constitution essentially prohibits structural deficits. To continue building up Lindner’s equity reserve, future governments might have to cut social-investment policies that would raise workers’ productivity (such as by financing training) or grow the workforce (as by extending nursery education)—policies whose benefits multiply throughout the life course. Even if through legalistic gymnastics the equity reserve were declared a financial transaction (under German fiscal rules exempt from the debt brake), would this be the most productive use of such large sums?
Norway’s fund
On the face of it, the Lindner proposal resembles the successful sovereign-wealth fund in Norway. The two cases, however, are very different.
The Lindner fund is to be financed from government debt, with the risk that higher government borrowing raises the interest rate and so the burden of future debt-interest payment. The risk of crowding out future investment is then real, regardless of German fiscal rules. The Norwegian fund, accumulated mainly by top-slicing oil revenues, faces no such risk.
More generally, of course, any reform with the aim of increasing output in the face of the looming climate catastrophe, and with advanced economies already living beyond planetary means, has to be eyed critically. In fact, a stronger case for the Lindner fund would be its potential role in financing the transition to a green economy, through including strong guidelines in the fund’s terms of reference. Such an argument should appeal to fund managers, because investments in fossil fuels are likely to become stranded assets. So far, however, there have been no efforts to turn the equity reserve into a vehicle to accelerate the green transition.
Separate from, and in addition to, the green-investment argument, there are other ways to rebalance the financing of pensions in Germany. These include raising the pension age, as is taking place in many countries—albeit with outliers, such as the resistance in France to the proposal to raise the pension age from 62 to 64.
Politically difficult
Faced with rising pension costs, governments could cut benefits or increase contributions for the working-age population or raise taxation generally—all of which are politically difficult. The only other policy direction is to increase output sufficiently to pay the pensioners what they were promised without increasing taxes or contributions.
As with many such suggestions, the Lindner proposal focuses on pension finance rather than output. An optimist would argue that the proposal might help but in economic terms be at best only marginally beneficial. A more critical view is that, while appearing economically sensible, it would simply kick the can down the road. Finally, in a cynical view, a politician from Germany’s most market-oriented party is aiming to divert to private financial markets funds the government could use for social investment.
Fabian Mushövel is a Marie Skłodowska-Curie research fellow at the European University Institute and a visiting fellow at the London School of Economics. His research focuses on the political economy of welfare states, inequality, technological change and the eurozone.
Nicholas Barr is professor of public economics at the London School of Economics and author of numerous articles and more than 20 books, including The Economics of the Welfare State (sixth edition 2020) and (with Peter Diamond) Pension Reform: A Short Guide (2010).