Germans’ realization that they may not be able to rely on a state pension to maintain their living standards in retirement is fueling expansion of the country’s mutual fund market. From 1985 to 1995, volume grew at a compound annual rate of 21 percent. How the market develops from here depends on what the German government does further to encourage private pension provision. But even without tax incentives, we estimate that the mutual fund market will continue to grow by about 14 percent a year, reaching DM1.5 trillion by the end of 2005 (Exhibit 1). That could translate into revenue of DM26 billion for the industry, compared with about DM8 billion today.

Who succeeds in winning this new business will partly depend on the future design of the German pension system. But much also depends on the role the various operators choose to play in what is set to be an intensely competitive market.

More mutuals

The move into mutual funds has been spurred partly by the fact that they have tended to yield higher returns than the deposit accounts usually favored by Germans, and partly by the looming crisis in the country’s pay-as-you-go social security pension system. If current demographic trends continue, the proportion of the population over 60 will rise from 21 percent today to 34 percent by 2030. To pay all these extra people a state pension that matches current levels, contribution rates would have to rise some 20 percent to about 34 percent by 2035. Add to this increased contributions to health and long-term nursing care insurance, and Germans could find 40 percent of their pay packets being swallowed up by provision for their old age. The alternative is to cut state benefits, forcing people to start their own additional savings schemes to fund retirement. Market research indicates that almost 60 percent of the population under 50 is not convinced that public pension provision will suffice.

We estimate therefore that the share of total personal financial assets held in deposit accounts will fall from 44 percent today to about 35 percent by 2005 as individuals seek better returns from long-term investments. In the United States, this share has already fallen to 15 percent.

Regulatory uncertainty

The type of private pension plan that emerges in Germany will hinge on government decisions regarding tax incentives and the role companies should play in retirement schemes. Within these parameters, there are three main possibilities for handling individual retirement savings, though they are not exclusive (Exhibit 2).

Designated retirement funds. If public policy on tax incentives for private retirement savings and companies’ role in them stays much the same, individuals will start putting whatever they can afford into long-term savings products. Currently, life insurers are regarded as almost the only worthy custodians of long-term savings. Hence the proposal from the association of German investment companies (the BVI) to introduce Pensions Sondervermoegen—mutual funds that the government would explicitly recognize as suitable pension vehicles. The rules governing such funds could stipulate, for example, that at least half of a fund’s volume be held in equities or real estate at any given time to ensure adequate long-term returns and protection against inflation.

According to the BVI, legislation covering Pensions-Sondervermoegen could be contained either in 6. KWG-Novelle, an amendment to laws governing banks, or 3. Finanzmarktfoerderungsgesetz, legislation aimed at making the market for financial products more attractive. These two pieces of legislation could be passed in July 1997 and early 1998 respectively.

Individual retirement accounts. These products, known as IRAs and already popular in the United States, are likely to emerge if the government encourages citizens to fund individual private pension plans by offering incentives such as tax relief on mutual fund investments and/or tax-free returns. This type of product is likely to be favored by the five largest investment companies (ADIG, Deka, DIT, DWS, and Union), which in turn belong to the five leading retail banking groups in Germany. These banking groups account for almost two-thirds of all mutual fund sales; with little effort they would be able to use their extensive branch networks and close customer relationships to sell IRA-type retirement products (as well as Pensions-Sondervermoegen) offered by their investment arms in a one-step sales procedure directly to the end customer.

Employer-sponsored plans. A second scheme related to tax incentives involves employers who deduct payments (up to a maximum amount) from an employee’s gross salary and transfer them directly into a private retirement account. These schemes are again common in the United States, where they are known as 401(k) products, and entail the employer designating one or more mutual fund providers and then allowing employees to choose which should manage the funds in their accounts.

Building custom for these products is therefore a two-step process requiring sound corporate relationships and a strong retail brand. For foreign wholesale banks or other independent mutual fund providers that already enjoy good relationships with leading German corporations, this kind of pension plan might offer the easiest route into the German market. Likewise, the insurance companies (mostly German) that already sell insurance contracts through employers in a similar manner (Direktversicherung) could have an edge if 401(k)-type products were to emerge as an important vehicle for private pension provision.

Potential roles in the market

Although uncertainty about the regulations governing pension products poses one difficulty for those eyeing the mutual fund market, a more taxing problem is that of market entry. This is because the area is highly concentrated, with the five largest German investment companies and their retail banking parents accounting for more than 80 percent of the market in terms of fund management—roughly two-thirds of all mutual funds sales. Foreign companies are showing keen interest in the market, however: in the past four years, the number taking the regulatory steps that would permit them to compete in it has almost doubled.

Investment companies already operating in Germany and potential new entrants can choose between four roles. These differ in the extent of service delivered directly to the retail customer, and in the revenue they generate (Exhibit 3 and Exhibit 4).

Subadvisory. Under a subadvisory contract, funds are kept and branded by the client, but a subadvisor manages a specific portion—those assets destined for non-European equity markets, for example. A subadvisory role is a relatively quick way to amass assets under management. In line with the low investment requirements and low associated risk, however, the upside potential is also limited. Subadvisors earn only a fraction of the available management fees, which represent about 35 percent of total potential revenue.

Private labeling. Private-label contracts specify that entire funds are kept and managed by an investment company, although they are still distributed under the client’s brand name. This increases revenue by adding transaction fees, which account for 15 percent of the total revenue possible. In addition, slightly higher management fees can be expected in return for fund servicing and processing. Empirical evidence suggests, however, that private labeling is not the route to building significant volume, revenues, or presence in the German market.

Third-party distribution. Under a third-party agreement, an investment company distributes proprietary funds under its own brand name through financial intermediaries such as retail or direct banks, insurance agents, or independent investment consultants. Several foreign companies have already discovered how difficult it is to build a sizable presence in this manner, given the absence of strong independent distributors in Germany. In terms of investment requirements, however, third-party distribution is obviously cheaper than building proprietary distribution facilities.

Fully integrated. A fully integrated investment company covers the entire business system, from fund management to proprietary distribution through a branch network, a salesforce, or direct sales. It is able to exploit the full revenue potential of mutual funds, including the sales charges that account for about 45 percent of total revenues. It also captures the value associated with having access to addresses and other customer information that represent important marketing assets.

Although this role appeals as a means of building significant market presence, it also requires considerable investment (and therefore involve higher risk). Besides building servicing and processing infrastructure, companies will have to advertise massively to establish a retail brand name. In the case of direct distribution, a new entrant might have to spend more than DM25 million a year on marketing in the first years.