In 2009, for the first time in six years, the German economy shrank. With a 5% drop, the decline in the price-adjusted gross domestic product (GDP) was larger than ever since World War II. German pension funds (Pensionskasse) have not escaped unscathed from the financial crisis, but they have proved among the best performers in Europe.

German pension funds are con-servative and risk-averse investors. "A substantial proportion of German pension funds are structured along the lines of insurance companies, having to apply certain asset allocation restrictions. Furthermore, Germany has far tougher regulatory requirements than in typical prudent man rule driven environments," explains Nigel Cresswell, invest-ment leader at Towers Watson.

Consequently, compared to pension funds of other European countries, German Pensionskasse have a much lower equity ratio in their investment portfolio.

Indeed, the 2009 European asset allocation survey, by Mercer, showed that UK pension schemes' equity allocation was 54%, whereas in Germany the figure for this asset class allocation was 6%. Equity exposure within pension schemes for the whole of Europe, excluding the UK, was 42%.

Despite the fact that this low level equity exposure has helped to bolster German pension funds throughout the crisis, there is scep-ticism within the industry. Robert Schlichting, head of institutional business at Schroders points out that a lot of pension plans have now missed the equity rally of 2009.

According to the Versicherung-saufsichtsgesetz (VAG), which is the German law governing insurance companies and professional pen-sion schemes, German pension funds are allowed to invest up
to 35% in so-called 'risk-taking' asset classes such as equities or up to 5% into hedge funds and commodities. Some large corporate pension funds have managed to get special permission to go beyond the allocated figure in the past. Nonetheless, German pension funds only invested 13.1% in 'risky asset classes' in 2008 overall, according to the Bundesanstalt
für Finanzdienstleistungsaufsicht (Federal Financial Supervisory Authority). A similar figure is expected for 2009.

Another requirement of the Pensionskasse is that it meets risk management requirements, such as: asset liability management, stress-testing, and structural reor-ganisation and revision. "As for equity investments, one of the main issues for pension funds is the required risk budget from the stress test imposed by the 'Bundesanstalt für Finanzdienstleistung-saufsicht'," argues Dr. Klaus Mössle, head of Fidelity's German institutional business. The stress-test is seen as an 'early-warning system', to ensure pensions funds are able to meet their liabilities (funding level above 100%) and cover the required regulatory capital - despite a crisis on the capital markets, and without having to resort to taking counter measures. If the 'Pensionskasse' does not pass the stress-test, the regulator can insist on investment relocation within the portfolio. Mössle explains further: "If funding levels are relatively low [close to 100%], then you have little room for equity investment even though the insurance and pension fund law generally allows equity investments up to 35%."

Many pension fund and asset managers in Germany would like to have a higher exposure to equity and would like to be able to react earlier to new investment topics.

"I think pension funds should get more flexibility to invest in other vehicles or in other products, such as absolute return and UCITS III strategies; hence using more a risk based approach," states Werner Kolitsch, head of Germany & Austria at Threadneedle. Kolitsch also warns that the current low interest rate environment is very dangerous for a portfolio which is high weighting in government bonds. "Interest rates are going to rise in 2010. Pension funds now have to add uncorrelated returns to their portfolio. Consequently, asset allo-cation in high risk assets, for example in emerging markets and high yield markets will increase probably rapidly due to the fact that short term interest rates will rise."

Schlichting predicts that in spite of the tough regulations, going forward Germany will see more investment in emerging markets. "An ongoing trend will still be commodities, as a diversifier which will go via futures and not via equities. In the credit area I think we will see a possible trend to global credits, compared to a European trend in 2009." Larger German pension funds, typically those of multinational organisations with strong governance capabilities, have increasingly embraced Liability Driven Investment (LDI) structures as part of better managing the risk/return trade-offs of managing assets against liabilities. Cresswell believes that this trend will continue in 2010, in particular as the events of 2008 and 2009 lead investors to become increasingly more net risk focused in assessing their asset allocation.

What has Germany done to respond to the market uncertainty?

Market changes
There is still a lot of scepticism among institutional investors. In a market survey December 2009, German ratings agency Feri has found one in four German institutions replaced managers after the crisis. Roland Gill, director at bfinance agrees that review of managers and manager changes have increased in 2009, which is mainly due to performance reasons. "Many changes are a result of the consolidation within the industry; the regulatory environment has forced some pension funds to reduce risks. Simultaneously, methods to monitor and control risks have been improved," explains Cresswell.

A tool increasingly used in Germany to control risk and to improve reporting standards is the so called Master KAGs, 'Master Kapitalanlagegesellschaft'. It only exists in Germany and Austria and is an administrator platform, allowing the investor to receive consolidated reports for all investment funds on the portfolio. "Master KAGs are very helpful for the investor, in terms of the reporting and transparency of the status of investments," outlines Dr. Carl-Heinrich Kehr, principal, investment consulting at Mercer Germany. It has been predicted that there will be a continuous increase in Master KAGs.

Fiduciary management recently enjoyed press headlines, when the German detergents and cosmetic group Henkel outsourced the asset management of €2 billion (£1.7 billion) in pension assets to BlackRock, in June 2009. Nevertheless, Kehr believes: "Fiduciary management is still more a supply driven, rather than demand driven product. The current demand or current market interest is much more limited than the figures of published statements suggest."

Pension asset pooling, which has its foundation in the cash pooling model, was particularly successful in 2005 and is back, yet again, in the headlines. In December 2009, for example up to €6bn in pension assets of Deutsche Bank's German employees have been assembled in Luxembourg. Assets of employees in other European countries are going to follow. "Pension asset pooling is coming. It is still a process that requires time, as internationally different regulatory need to be harmonised," states Schlichting. Pension asset pooling is particularly useful for big pension funds. However, it is important to analyse and weigh-up cost implications against benefits. Gill is rather critical of asset pooling: "Major Corporate institutions use a central division and competence centre for global strate-gic asset allocation and manager search without pooling the assets."

Government initiatives
Industry experts anticipate significant changes for pension funds in 2010/2011, since the Bilanzrechtsmodernisierungsgesez (BilMoG) - the German act to modernise accounting law - was passed in 2009, and has to be implemented in the fiscal year following 2009. "One of the main reasons to have set up the 'BilMoG' was to have a German solution for small and medium enterprises and not to rely on the IASB [International Accounting Standards Board]. Nevertheless the local German accounting standard [German GAAP - Generally Accepted Accounting Principles] will come closer to international standards," explains Stefan Oecking, Head of International Retirement Group at Mercer Germany.

He continues: "One effect is that for the majority of direct commitments (Unmittelbare Versorgungszusagen) we will see a requirement to increase the balance sheet reserves without any tax implications. This will have two effects: an increased awareness of the costs of pensions for small and medium-sized businesses because the 'Mittelstand' is still doing their accounting with German GAAP and the second issue is how a company can make these pension benefits tax efficient." Companies with sufficient liquidity will transfer direct commitment to externally funded solutions in order to exclusively reserve the assets for pension payments, to net assets and liabilities, plan returns and plan costs on the accounting side, as well as to receive higher tax deductions. Therefore, an increase in these solutions will occur, as well as an added trend of moving away from defined benefits and final salary schemes.

In a low yield environment, BilMoG will increase liabilities in the very short term, due to the lower discount rate being used. Mössle explains: "The most frequent discount rate used in the past was 6%; with current market yields BilMoG will require a significantly lower rate in the range of 4 to 5 per cent. This will result in higher liabilities for the time being."

Third pillar pensions?
Germany still runs the risk of underfunded pension provision, with 83% of the funds being provided by the state pension system - only 17% is provided by a funded instrument. Recent studies by Postbank also revealed that since the crisis nearly every fifth employee has either cancelled or reduced personal pensions provision contracts.
A definite trend in the market is the state-subsidised 'Riester-Rente', a state-run, tax-incentive, additional pension for the private and company pension schemes. "Riester-Rente is an important move towards a personal, individualised, private pension plan. It receives increased acceptance, with some 250,000 new contracts in the third quarter of 2009. Overall 13 million contracts were made at the end of 2009. This covers a main part of the working population in Germany," states Kehr.

Yet, Dr Hartmut Leser, a Member of the Executive Board at Aberdeen Asset Management Germany, is concerned about the actual gain for the individual: "Tax advantages end up not being for the investor. They just bear the risks. An individual doesn't have the chance to understand all mechanisms. Riester-Rente products are not transparent enough."

Further government initiatives to accelerate private savings such as the 'Eigenheimrente', a state support of Riester pensions included in self-inhabited private property through state contributions or tax deductions on mortgage payments; 'Rürup pension', an optional additional payment to the mandatory contri-butions with a cap at €20,000 per year; Time Value Accounts; and direct insurance have not picked up yet and are unlikely to do so in the near future, due to the lack of transparency, too specialised products and lack of financial inducements.

Something has to change; Germany needs further personal pensions initiatives. Mössle believes: "Without any additional private savings, the state pillar will only cover about 44% replacement rate. The value of state pensions will go down in absolute terms for each individual. It is clear that people will have to do more for their private savings." This can then be a possibility for employers to further encourage the workforce and to look more attractive for future employees. Leser concludes: "We should not forget the factor of 'moral hazard': The state won't let me starve when
I have retired and will look after me."

Written by Dorothee Gnaedinger, a freelance journalist

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