Academic Urges Chilean-Style Reform for Germany

By Jan Wagner, IPE

October 12, 2006

A leading economist has called for Germany ’s pay-as-you-go state pension system to be replaced by a Chilean-style capital-backed arrangement.

Professor Jürgen Donges, a former member of the government’s council of economic advisors, argues the current system is unsustainable.  

“German politicians have never liked to admit it, but it has been clear for decades that the state simply can’t finance the current PAYG system,” Donges told an event in Cologne marking the 60th anniversary of German pensions advisor Heubeck AG. Donges cited demographic trends as a major reason why PAYG was unsustainable.

Germany ’s birth rate – at 1.4 children per mother – has fallen to one of the lowest in Europe . Germans are also living longer. Heubeck itself has recently calculated that employees retiring at 65 will draw a pension for a maximum of 17 years after then.

“The government’s recent pension reforms have been an important first step, but it is my view that in the long-term, there is no alternative to a capital-backed system. Countries like Chile have already shown us how it can be done,” Donges, who is an economics professor at the University of Cologne , said.

In Chile , the PAYG system for the state pension was replaced with a scheme whereby an employee contributes, on a tax-deferred basis, at least 10 percent of wages into a fund. The fund’s assets are then managed not by the government but by external managers.

The Chilean government does, however, protect, accumulated savings from insolvency of an asset manager. The employee is then asked to select another solvent asset manager. Finally, savings from the fund are withdrawn and taxed when male employees turn 65 and when females turn 60.

Donges acknowledged that a capital-backed system carried certain risks, including those linked with investment performance, inflation and the possibility that the government could raid the savings.

“But these risks can be minimised by, for example, setting clear investment restrictions and guidelines, ensuring effective supervision and barring the government from tapping the savings for its budget,” he noted.