Capital payments, (partial) capitalization, and capital option as structuring choices for company pension schemes: Update 2025

Capital payments as content of bAV commitments include company pension benefits that the employer grants either as a one-off amount or in several – in practice, regularly annual – instalments, and through which the employer fully fulfils its company pension obligations arising from the bAV commitment and thus extinguishes them. This temporally limited nature distinguishes them from the alternative monthly pension benefits, which the employer has to grant until the ‘last breath’ of the pension beneficiary – and, where survivor benefits are promised, to surviving dependents as well – and thus bears the longevity risk for the group of beneficiaries. Lump-sum benefits significantly increase planning security for employers. F rom the beneficiaries’ perspective, they are often not as commercially attractive as monthly pension benefits: Due to the general tax liability pursuant to Section 1 of the German Income Tax Act (Einkommenssteuergesetz, EStG), company pension payments are subject to taxation under Section 19 EStG. In view of the progressive tax rate pursuant to Section 32a EStG, lump-sum payments are, even by considering the application of the so called one-fifth rule pursuant to Section 34 EStG in the individual case, very often subject to a higher tax burden than monthly pension payments.

1. Lump-sum benefits vs. pension benefits in a comparison of advantages

The legislator has not specified that only monthly pension payments or capital payments may be granted, and insofar the employer must assess the respective advantages when designing or modifying company pension schemes. In its case law, the BAG has already established several legal principles for the effective design of a possible capital option in new company pension commitments and for the effective modification of existing company pension commitments in order to change the benefit structure to include an optional or alternative capital payments, which the employer must take into account in its decision-making.

For employers, the following commercial and legal advantages arise for capital payments over pension benefits:

• Capital benefits are not subject to the adjustment obligation (so-called review obligation) under Section 16 of the German Company Pensions Act (Betriebsrentengesetz, BetrAVG). The scope of application of Section 16 BetrAVG only covers current pension payments (Section 16 (1) BetrAVG). In practice, it is challenging to distinguish these from capital payments in individual cases in which the capital payments are paid out in instalments or annuitised. As far as it can be seen, the BAG has not yet had the opportunity to rule on this and establish generally applicable legal principles. The distinction should be made based on the specific purpose of the pension benefit, and a capital payment granted in instalments should not be classified as a regular pension benefit within the meaning of Section 16 (1) BetrAVG if the purpose of the pension is to serve the accumulation of capital for the beneficiary in addition to covering (monthly) maintenance. This can – without change – still at least be assumed, based on a standardised approach, for capital payments that are granted in up to 10 annual instalments.

• The employer does not assume the longevity risk for the individual beneficiary, which, in the case of the granting of survivor's benefits in the company pension scheme, includes not only the longevity of the employee but also the longevity of the surviving dependents. If the employer has fully granted the capital payment to the employee prior to his death and thus fulfilled all pension obligations arising from the specific company pension commitment, the surviving dependents have no further claims arising from the company pension commitment.

• Furthermore, non-application of Section 16 BetrAVG and non-assumption of the longevity risk in the individual case often results in the employer more favourably accounting for the pension obligations than it would if it granted monthly pension benefits. in which the non-consideration of the mortality tables, which are subject to an unaltered increase in the probability of longevity, and the pension adjustment factors relevant to Section 16 BetrAVG when determining the pension provisions, often overcompensate for the (interest) interest effect from the earlier maturity of the capital payments compared to the monthly pension benefits.
  
  
• When the company pension commitment is implemented through an external provider (in particular through direct insurance or a pension fund (Pensionskasse or Pensionsfond), the capital payment in the individual case often offers a commercial advantage and also leads to lower financing costs in the vesting period when calculating the monthly/annual amounts if the capital payment is the only form of benefit promised. This also applies in view of the adjustment relief specified in Section 16 (3) no. 2 BetrAVG in the implementation options of direct insurance and the pension fund (= fulfilment of the adjustment obligation by exclusively using the relevant profit shares to increase current benefits).
  
  

Conversely, regular pension payments are generally more advantageous for the beneficiaries with the respective reciprocal argument. This is mainly due to the lower tax burden, which often has a milder effect on pension payments. In addition, pension benefits are subject to wider protection against attachment from the point of view of the beneficiary, in accordance with Section 850c of the German Civil Procedure Code (Zivilprozessordnung, ZPO) (= consideration of the exemption limits ex officio), compared to the protection against attachment for capital payments (only) resulting from Section 850i ZPO (= separate judicial protection against attachment only at the request of the beneficiary).

Exceptionally, lump-sum benefits are more favourable for the individual beneficiary if the beneficiary has a significantly lower life expectancy than the calculation originally used by the employer to determine the amount of the benefit. In this case, the lump-sum benefit represents a materially higher increase in assets than the cumulative total of the pension benefits granted by the employer until the beneficiary's death.

2. Status Quo regarding the design of new company pension schemes I: Lump-sum benefits as a standard pension benefit – possible without restriction if granted exclusively or by granting employee relevant options

The agreement of capital payments as the sole form of benefit in a newly designed company pension commitment is legally permissible without restriction and is often determined by employers in this way due to the initial situation with regard to company pensions and taxation.

The granting of an option for the beneficiary to receive the specific pension benefit as a capital payment or as a pension payment is also permitted without restriction. In practice, this option is regularly provided with a time limit for exercise (usually between 3 and 6 months before the pension benefits fall due) so that the employer can make the necessary administrative arrangements for the smooth provision of the pension benefits.

The time frame for exercising the right to choose is of particular legal relevance, since, according to the case law of the BAG, the exercise of the right to choose a capital payment is subject to the requirements of Section 3 BetrAVG , and an election of a capital payment (only) at the time of termination or even after termination of the employment relationship would be invalid under Section 3 BetrAVG.

Corresponding ‘older’ pension commitments (especially those existing in SMEs) currently still predominantly provide for pension benefits as the standard benefit form. However, the beneficiary may, by exercising the option right, partially or fully replace these with a lump-sum payment. In the event of only partial capitalisation, the BAG has already ruled that the remaining portion of the pension benefits granted as a pension is subject to the adjustment (review) obligation under Section 16 BetrAVG (see only BAG judgment of 20 June 2023, 3 AZR 231/22).

Alternatively, company pension schemes can also provide for the capital payment as a standard benefit, which the beneficiary can replace, in whole or in part, with a pension benefit by exercising the right of choice. The question of whether the pension benefit granted as a pension after the corresponding exercise of the right of choice is subject to the adjustment (review) obligation under Section 16 BetrAVG has not yet been decided by case law for this group of cases. In practice, some authors in the literature deny the application of Section 16 BetrAVG on the grounds that the beneficiary's right of choice should not change the employer's chosen initial system of a capital payment. Risk-conservative employers can eliminate the legal uncertainty that exists in this regard by not applying the right to choose to a pension benefit that is an alternative to a capital payment, but by offering the beneficiary of the pension benefits in the company pension scheme (alone) the options of a one-off or instalment capital payment.

3. Status quo of the conceptual design of new company pension schemes II: Employer's right of choice only if the actuarial present value of the pension benefits is at least as high

If the employer reserves the right to grant the pension benefits as a lump sum payment in the newly designed company pension commitment with the pension as the standard pension benefit, a distinction must be made for the effective exercise of the right of choice according to the legal basis of the company pension commitment:

The BAG has already ruled that, for the legal basis of the company pension commitment as an individual commitment or a general commitment, such a right of choice must meet the requirements of Sections 308 no. 4 and 315 of the German Civil Code (Bürgerliches Gesetzbuch, BGB) and that the exercise of the right to choose as a lump sum benefit must therefore be reasonable for the beneficiary, taking into account the employer's interests (BAG judgment of 17 January 2023, 3 AZR 220/22, 3 AZR 501/21). In its judgments of 17 January 2023, the BAG further specified these general requirements for reasonableness, according to which (1) the capital payment granted in the event of a claim must at least correspond to the actuarially determined present value of the current pensions, and (2) the reserved capital option right must be exercised within the bounds of reasonable discretion, which requires a balancing of interests between the employer's interest in exercising the option to provide a capital payment and the pension beneficiary's interest in receiving the pension as an annuity (in particular with regard to the advantages over the capital payment as set out in point 1). The BAG has recognised the following as general interests of the employer that can be taken into account: uncertainties in the benefit phase, changes in the economic and/or legal framework, calculability of the benefit, reduction of administrative expenses, enabling a company sale and/or granting as a capital payment for general improvement of benefits. The BAG requires an overall assessment taking into account all circumstances for the specific weighing of interests. In the opinion of the BAG, the assessment of the equivalent actuarial amount of the cash value of the capital payment compared to the accumulated pension benefits should be carried out by the employer at the time of the occurrence of the insured event. In practice, this requirement often causes considerable uncertainty for employers, especially when the capital option is exercised with a corresponding time lead before the insured event occurs.

The BAG has not yet had the opportunity to decide whether the above-mentioned legal principles should also apply to an employer's right of choice granted in a collective legal basis (works agreement (Betriebsvereinbarung)/service agreement (Dienstvereinbarung) /collective bargaining agreement (Tarifvertrag)). From a legal point of view, there are substantive reasons for substantiating the statutory legal bases of Sec. 75 of the German Works Constitution Act (Betriebsverfassungsgesetz, BetrVG) and the respective staff representation law with comparable requirements for the control of the content and fairness of works agreements or service agreements.

In its judgements of 17 January 2023, the BAG also found that the above-mentioned legal principles do not apply if the employer's decision on the content of the pension benefit is structured as an optional debt in accordance with Section 262 BGB. An optional debt exists if the employer is free to choose between the planned payment options, i.e. if no ranking has been implemented in the legal basis between the payment options for the pension benefits, for example if these are linked with the word ‘or’. In this case, the employer's payment obligation only materialises when the right to choose is exercised. When the company pension commitment is granted, it is already apparent to the beneficiary that the employer is free to choose from a variety of options when granting the pension benefits and that each form of payment is to be regarded as a principal service in its own right. In the opinion of the BAG, the clause and the employer's decision are then also not subject to the review of general terms and conditions.

4. Modification of existing company pension scheme commitments on the basis of a works agreement: general proportionality test

In practice, company pension scheme commitments usually still provide for the exclusive granting of monthly pension payments. In view of the considerations regarding the advantages as set out in point 1, employers often have an interest in retrospectively extending existing company pension schemes to include the option of a capital payment. In practice, such an addition is sometimes made by including a corresponding option for the employer in the company pension scheme or even by directly modifying the pension benefit from a pension to a capital payment in the supplementary agreement.

If the original company pension commitment is based on a works agreement/service agreement, this can, from a formal point of view, be supplemented by a collectively agreed supplementary agreement in accordance with the principle of collective replacement. In this case, the modification of the company pension commitment by means of the additional company/service agreement generally only covers employees with pension benefits who are actively employed, since only these employees are represented by the works council/staff council at the time the supplementary agreement is concluded. Beneficiaries who have already left the company are only covered by the supplementary agreement if the original company/service agreement contains a dynamic reference to its possible amendment/replacement.

According to the case law of the BAG (judgment of 20 June 2023, 3 AZR 231/22 and judgment of 15 May 2012, 3 AZR 11/10), the content of the superseding works agreement/service agreement must ultimately meet the substantive criteria listed in section 3 and therefore (1) the amount of the capital payment must have at least the same actuarial capital value as the pension benefits, and (2) the employer must carry out a comprehensive balancing of interests for the effective modification to a capital payment and the insertion of the option for a capital payment and its exercise. In its ruling of 20 June 2023, the BAG found that if only part of the company pension benefits are capitalised (e.g. if only the further entitlements from the company pension commitment that can be earned from the time the supplementary agreement is concluded (future services) are granted as a capital payment and the entitlements already earned (past service) continue to be granted as a pension benefit), the disadvantages for the beneficiary listed under point 2 are relativised and his interest in maintaining the originally exclusively promised pension benefits is to be given less weight.

5. Modification of bAV commitments based on an individual legal basis: In general, only amicable changes and replacements by works agreement/service agreement (only) in the case of a risk-related approach)

If the original company pension commitment is based on an individual legal basis (individual contractual agreement with the beneficiary/general commitment/company practice/principle of equal treatment under labour law), an effective modification can be achieved at the starting point (only) by means of a supplementary agreement with the beneficiary.

If the beneficiary rejects the conclusion of the supplementary agreement, employers with a (larger) risk affinity may modify the content of unilateral employer statements/individual commitments by concluding a works agreement/service agreement that uses the legal principles of the more recent case law of the Third Senate of the BAG – which is responsible for company pensions – to replace such individual legal bases with a collective impact through a company agreement (judgment dated 13 January 2025 (3 AZR 897/12, general commitment), judgment dated 21 February 2017 (3 AZR 452/15, individual commitment), judgment dated 23 February 2016 (3 AZR 44/14, company practice)). When deciding on such a replacement by a works agreement, the employer must bear in mind that the Fourth Senate of the BAG generally rejects the possibility of replacing an individual legal basis with a company agreement (BAG judgment of 11 April 2018, 4 AZR 119/17). Furthermore, in this group of cases, too, employers must bear in mind that, when modifying a company/service agreement, this can generally only cover employees with an active employment relationship who are entitled to a pension. In terms of content, the service/company agreement modifying the original company pension commitment must meet the requirements set out in no 4.

6. Practical implications: Risk-appropriate design of the capital payment option in new pension commitments and necessary careful modification of existing company pension commitments

In the future, employers should either provide for the lump-sum benefit as the sole pension benefit or as an option when designing new company pension commitments. In the case of existing company pension schemes without a capitalisation option, a supplement can be added or even a direct conversion to a capital payment can be made in individual cases – provided that the pension benefits are calculated with the equivalent actuarial present value and the employer weighs up the interests of as many of the interest positions already recognised by the BAG as possible. Where collective legal bases are affected, it is necessary to convince the works council or staff council of the need for modification. In addition, employers must apply the general ‘three core principles of the modification of company pension commitments’: (1) Careful and complete documentation of the relevant considerations for the modification (paper trail ‘also for posterity’), (2) needs-based communication with the beneficiaries (necessity of the modification), (3) consistent implementation of the modified pension commitment (consistent approach).
 

Published: April 2025