Germany: Optimizing Severance Pay to Finance Early Retirement

  • Providing pension contributions to the German state pension scheme instead of making severance payments can be an attractive alternative for the employer and employee.
  • Employees benefit by longevity risk coverage for early retirement, and employers enjoy a significant tax exemption.

Little known and therefore little used in Germany is the option of providing pension contributions instead of severance pay. If an employee has plans to retire early, or if a mutually agreed termination of the employment relationship is intended specifically to facilitate an early transfer to retirement, voluntary contributions to the German state pension scheme instead of a severance payment can be an attractive alternative.

Employees aged 50 and above who plan to retire early can take advantage of considerable tax benefits in this way, in addition to reducing pension reductions.

The basis for this practice is the social insurance law provision § 187a SGB VI. This provision allows for the possibility of compensating for pension reductions incurred as a result of early retirement by making voluntary payments until the standard retirement age is reached. If the payments are made directly by the employer, they are tax-free to a considerable extent.

Legal Background

If employees plan to take early retirement, for example in the course of a mutually agreed termination of employment or after partial retirement or bridging unemployment, they face lifelong deductions from their pension entitlement. Retirement pensions can generally be taken early from age 63, before the regular retirement age of 67 (staggered from 65 to 67 for those born up to 1963). In return, the employee must accept substantial deductions of 0.3% per month of early retirement, up to a maximum of 14.4%, for life.

Such deductions can be mitigated or even completely prevented by so-called compensatory payments into the pension account at the Deutsche Rentenversicherung Bund (hereinafter: DRV). These payments can be made by the employee or by the employer, either as a lump sum or in several (also monthly) installments.

Advantages: Longevity risk coverage and significant tax exemption

Significant advantages of pension equalization payments over a simple severance payment lie in their temporal follow-up effect. The classic severance payment as a fixed sum is finite in its timeframe as a means of compensating for early retirement—i.e., it will be used up at some point. In contrast, the (partial) compensation of the deductions results in a lifelong increase in the reduced pension. Compensation payments thus hedge the longevity risk.

At the same time, pension compensation payments made by the employer are to a very considerable extent tax- and social security-free. Compensation payments are taxed according to the so-called one-fifth rule. Employees with incomes close to or above the top tax rate (2023: taxable annual income of EUR 62,810) regularly benefit from this tax privilege to only a small extent or not at all. In contrast, compensation payments by the employer are entirely tax-free up to 50% of the compensation sum required to compensate for the expected pension deductions. The amount of this compensation sum is calculated by the DRV as part of an information procedure. Depending on the regular pension amount and expected reductions, it can reach a higher 5-digit amount.

Tip: A severance payment can also be structured as a combination of a pension equalization payment of up to 50% of the notified equalization amount and, in addition, as a classic severance payment. The employee can in turn use the classic severance payment to make payments into their pension account. These in turn are generally tax-privileged as special expenses.

Areas of application and combination with other bridging or optimization instruments

Areas of application can include employer-based early retirement programs as well as collective staff reductions or individual termination scenarios.

It is also interesting to combine them with other instruments for bridging the period until retirement, such as part-time work for older employees, the use of credit balances already built up or still to be built up to finance non-employment periods (working time accounts or long-term accounts), or the receipt of unemployment benefits. Furthermore, a combination with tax-privileged payments into a company pension scheme can also be attractive.

What are the requirements for making compensation payments to the pension insurance?

Compensation payments are possible under the following conditions:

The employee must:

  • Be at least 50 years old (or younger if there is a legitimate interest)
  • Be legally or voluntarily insured in the DRV
  • Have at least 35 years of insurance in the DRV up to the age of 63.

Information procedure:

  • The employee obtains information on the amount of the compensation sum from the DRV by means of a formal application.
  • In the information, the DRV informs the employee of the compensation amount; 50% of this can be paid tax-free by the employer. It is binding for three months.
  • The payment of the compensation itself is not binding for the employee. If the employee does not retire early after all, the contributions paid increase the monthly pension.

Challenges and advantages at a glance

Given the low level of awareness in practice to date, payroll accounting implementation can be challenging. In addition, with regard to the information procedure, the company is dependent on the employee submitting the application and is subject to a certain time requirement. The employee is strongly advised to seek pension and tax advice.

Nevertheless, we consider compensatory payments to the pension insurance scheme to be an often overlooked but very attractive means of structuring early retirement, because

  • a lifelong increase in the reduced early pension is achieved;
  • up to 50% of the compensation amount is tax-free if paid in by the employer;
  • the employee is nevertheless not tied down with regard to retirement; and
  • attractive combinations with other components of the transition to retirement are possible.

Information contained in this publication is intended for informational purposes only and does not constitute legal advice or opinion, nor is it a substitute for the professional judgment of an attorney.