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Just over a year into office, Chancellor Friedrich Merz’s coalition in Germany is deep in the doldrums. Hamstrung by infighting between its centre-right and centre-left partners, it has struggled to reverse Germany’s economic stagnation and waning competitiveness. Three cheers, then, for pension reform proposals unveiled last week with both partners’ apparent backing. This is the boldest move by Merz’s government since the relaxation of the debt brake for investment and defence, with positive implications beyond Germany.
Under proposals agreed by a bipartisan commission, a compulsory initial contribution of 0.5 per cent of employees’ pre-tax income, rising to 2 per cent by 2031, will go into a Swedish-style public pension fund managed centrally and invested in capital markets. Contributions are split 50/50 between employees and employers. The statutory minimum retirement age of 67 is set to rise in line with life expectancy; rights to early retirement for people with 45 years of contributions will be restricted.
Such measures have become vital to reduce the deficits of Germany’s unsustainable pay-as-you-go system. Some 16.5mn baby boomers will retire by 2036 with only 12.5mn new workers joining the workforce, according to some estimates. The government spent about a quarter of the total federal budget on plugging gaps in the system in 2024; economists say that could double to 50 per cent in two decades.
Linking the retirement age to life expectancy is projected to mean only a gradual increase — to 67.5 by 2041 and 70 by 2091. But economists say this is the only sound way to stabilise the system without spiralling payroll taxes or huge federal subsidies. Narrowing early retirement rights will address a drain of experienced workers amid acute skills shortages.
A downside is that the reform will increase social costs for employers — going against Merz’s campaign promise last year to cap social security charges at a time when Germany’s corporate sector is struggling and the economy flatlining. But the chancellor makes a compelling pitch that this as the only way to ensure contributions remain manageable over the long term.
The 33-point pension plan is also part of a broader planned overhaul of Germany’s welfare state, including health insurance and elderly care. It is vital the coalition presses ahead with the rest of the package, to relieve the burdens on employers. It also needs to set about tackling other overgenerous benefits, including the partial linking of unemployment benefits to prior earnings.
The plan could still unravel if MPs ask for too many tweaks and amendments. Assuming it succeeds, however, it will be a big step towards creating a capital market in Germany. Even though it will channel only about €30bn a year, it will nurture an equity investing culture — Germans are heavy savers, but mostly in cash or low-risk products — and create a bigger pool of investment capital. It belatedly brings Germany in line with the likes of Denmark, the Netherlands and Sweden, which acted much earlier to buttress pay-as-you-go models with capital market-funded pillars. It signals to investors that Berlin can still on occasion summon the political will to tackle deep-seated challenges, in contrast to the entrenched political paralysis over pension reform in France.
It may just, too, aid the EU push towards a capital markets union, long hampered by the historical wariness of the Eurozone’s economic engine towards equity markets. Having a market-funded pension pillar could provide an incentive to support deeper and more integrated European capital markets. It helps Berlin to future-proof its own retirement safety net — and also might help to create the political willpower finally to unlock Europe’s broader financial potential.
