Several, in particular large companies in Germany maintain, as an additional incentive for their employees, and generally on a voluntary basis, a pension plan fully or partially sponsored by the company. It is estimated that approximately 40% of all employees in Germany benefit from company pension plans. The total amount of assets and funds dedicated to cover pension liabilities, as well as of accruals set-up in balance sheets to cover “unfunded” pension liabilities, was EUR 538.5 billion in Germany in 2013. The majority of the corresponding pension liabilities (51.8%) are unfunded. In light of the considerable costs, there has been a tendency in recent years to close pension schemes. Such closures are, however, in general only permissible with respect to new hires, with the consequence that the pension liabilities existing as of the date of closure remain with the company for years and possibly decades, and decrease at a slow rate.
In the following article, we will provide an overview of the German pension system with a focus on the treatment of pension schemes in transactions, as well as in insolvencies.
Overview of German Pension System
The German pension system is based on three pillars:
- By mandatory law, all employees are subject to the statutory pension insurance maintained by the German state (i.e., the employer is not liable for it). The insurance is, in essence, financed by statutory contributions half borne by the employer and half by the employee (currently 18.7% in total of the individual employee’s gross salary up to EUR 72,600 (Western Germany) or EUR 62,400 (Eastern Germany) per year (“Salary Threshold”)).
- Unless mandatory under applicable collective bargaining agreements (Tarifverträge), companies can establish, on a voluntary basis, company- sponsored pension schemes. Once such a scheme is established, the company is bound to the German Company Pension Act (BetrAVG).
- Due to the demographic change and a predictable shortfall of the statutory pension, the German state supports private pension savings by granting tax and social security advantages. In this connection, the employees have a statutory claim against their employer to withhold up to 4% of their salaries up to the Salary Threshold and defer these funds to a pension scheme.
Funding Principles of Company Pension Schemes
Whereas a company pension scheme can be introduced in multiple ways (e.g., by unilateral promise of the company or by agreements with the employees, works council, or union), the set-up of the pension scheme has to be in line with the German Company Pension Act.
The Act provides for the following five instruments (four thereof resulting in a “funding” of the pension liabilities):
- (unfunded) direct pension promise (Direktzusage)
- direct insurance
- pension cash funds (Pensionskasse)
- pension relief funds (Unterstützungskasse)
- pension funds (Pensionsfonds)
If the pension is funded via a direct insurance scheme, pension cash funds, pension relief funds or pension funds, the company pays contributions to the relevant external funding instrument. However, the company bears the capital investment risk vis-à-vis the employee, i.e., it is obliged to pay out at least the amount of pension promised to pay to its employees if there is a partial or complete shortfall of the funding instrument.
The only “unfunded” instrument provided for in the German Company Pension Act is the direct pension promise. As a consequence of granting a direct pension promise, the company regularly has to accrue the pension liabilities on its balance sheet. In practice, the company often enters into reinsurance policies to safeguard the pension liabilities. However, the value of a reinsurance policy may, in general, not be deducted from the pension liabilities that are to be accrued in the balance sheet pursuant to German GAAP. This situation changes if the company sets up a contractual trust arrangement (“CTA”), i.e., transfers assets to a trustee who is legally independent and may use the assets exclusively for the protection of pension liabilities. Although a CTA qualifies as a financing measure and not as a funding instrument in the meaning of the German Company Pension Act, the structure of a CTA generally allows a deduction of pension accruals in the balance sheet in the amount of the value of the plan assets transferred to the trustee under German GAAP.
Company Pension Schemes in a Share or Asset Deal Scenario
The direct or indirect acquisition of shares in a German entity that has funded or unfunded pension obligations does not have any impact on the pension situation at all: The German target entity remains as legal employer and, thus, the pension schemes and liabilities remain unaffected, as do any funding instruments established. This situation may change if the German target entity is part of a group and the group has set up its own funding instrument. In this case, the assets held by the funding instrument may remain with the group after the closing of the transaction, with the consequence that the carve-out of the German target entity results in an underfunding of pension obligations. However, this situation could be provided for under the share purchase agreement, either by the agreement on a transfer of plan assets to the target or by a respective purchase price deduction.
This situation is different in the case of an asset deal: Under German mandatory law, the transfer of assets that form a business unit results in all active employees attributable to this business unit transferring to the buyer with all employment-related rights and duties, including pension obligations. As a consequence, the buyer assumes all pension claims accrued by the employees actively employed with the business unit on the closing date of the transfer, with the claims being transferred in full to the buyer by operation of law. Pension claims accrued by individuals who left the business unit prior to the closing date (in particular pensioners and former employees) do not transfer to the buyer. A funding instrument in place (e.g., a direct insurance agreement or pension relief fund) does not automatically transfer to the buyer in connection with the asset transfer. Thus, a transfer needs to be agreed with the seller in the asset purchase agreement (and with the funding vehicle itself, if required). If the pension obligations vis-à-vis the transferring employees are unfunded, the buyer has to set up accruals for all pension claims of the transferring (i.e., active) employees. However, given that pensioners and other individuals who left the business unit prior to the closing do not transfer to the buyer, an asset deal scenario can result in a material deduction of pension liabilities for the buyer.
Company Pension in Insolvencies
According to German law, companies need to insure their pension obligations (other than those funded by pension cash funds) against insolvency with the Mutual Pension Assurance Association (Pensions- Sicherungsverein auf Gegenseitigkeit, “PSV”). The PSV has around 94,000 members (i.e., companies mandatorily contributing for insolvency insurance purposes) and protects the pension claims of approximately 10.9 million pensioners and employees with vested pension claims against insolvency of their employers. The value of the pension obligations insured by the PSV amounts to EUR 320 billion in total.
If insolvency proceedings are opened (or the application to open insolvency proceedings is refused due to a lack of assets), the PSV assumes, by operation of law, the liabilities for (i) current pension payments and (ii) pension expectancy rights vested according to the German Company Pension Act. The employees have a direct pension claim against the PSV. However, the PSV only assumes pension claims (or the pro rata temporis portion thereof) that relate to periods of employment prior to the date on which the insolvency proceedings are opened. The PSV is entitled to file its claims with the insolvency administrator as an unsecured creditor, ranking pari passu with all other unsecured non-subordinated claims.
The pension liabilities accrued until the date of the opening of insolvency proceedings will remain with the PSV even if employees of the insolvent company will be automatically transferred to a buyer in connection with an asset deal by operation of German law, i.e., in the case of insolvency, the buyer will only be liable on a pro rata temporis basis for pension claims that are accrued as from the day the insolvency proceedings were opened onwards.