Cash or pension – lump-sum option and right of substitution in the occupational pension scheme

Employers like to reserve the right to choose a lump sum in pension commitments. However, whether this can be claimed in individual cases depends on various aspects. The Federal Labor Court (BAG) has ruled on this several times in the past year.

Right to an error-free decision when exercising a right to vote

In the first case on the subject of the lump-sum option (BAG, judgment of 15 May 2019, 3 AZR 150/17), the pension commitment essentially stipulated: “One-off payment or installments or pension payment, taking into account the interests of the employee”. The employer excluded a benefit in the form of a pension when the insured event occurred. The beneficiary then rejected the payment and sued for annuitization of the pension credit. The employer had exercised its right to choose inadmissibly by excluding retirement from the outset, although the employee clearly had a greater interest in doing so. Due to his illness, which was known to the employer, he was unable to cope with a lump-sum payment and was therefore unable to secure his livelihood.

The BAG emphasized that the parties to the collective agreement are free to delegate the power to regulate and to grant one party a genuine right of choice. Beneficiaries are not entitled to a pension payment from such a pension commitment, but are entitled to a discretionary decision on the exercise of the right of choice.

Interim conclusion: Whether and to what extent a pension commitment grants an entitlement to retirement or whether a party may unilaterally determine the type of benefit depends on its legal basis. If no priority has been given to a specific type of benefit, the right to choose must nevertheless be exercised at reasonable discretion in accordance with Section 315 BGB. This means that the essential circumstances of the specific individual case must be weighed up and the interests of both parties taken into account appropriately. This balancing of interests is justiciable, which is why it should be carried out and documented carefully. It should be noted that the employer’s mere interest in excluding retirement due to additional economic and administrative burdens is not a sufficient argument compared to the other types of benefits. The suggestion of retrospective de-risking by way of capitalization must be rejected, as this expense from an annuity is typical of the assumption of longevity and

Distinction between elective debt or power of substitution

In further rulings, the BAG considered the distinction between two regulatory nuances to be significant: the obligation to choose on the one hand and the right of substitution on the other (cf. see the judgments of the BAG of January 17, 2023, 3 AZR 501/21 and 3 AZR 220/22)

In the case of a genuine elective debt within the meaning of Section 262 BGB, the employer owes several different benefits per se when the pension event occurs, but these are intended as specific individual debts. A service to be performed can be selected subsequently. This selection is then deemed to be owed from the outset.

A power of substitution, on the other hand, is not regulated by law, but is also recognized as a legal concept. It means the right to subsequently change the content of a specific contractual obligation. In contrast to an elective debt, the only performance owed is fixed from the outset in the case of the power of substitution and can be changed later. This distinction is relevant, among other things, because only a clause that contains a power of substitution or a reservation of the right to amend can be controlled under the law of general terms and conditions.

The replacement must be reasonable

The BAG decision 3 AZR 220/22 was based on a legal dispute in which a group support fund had reserved the right in its benefit plan to pay a one-off lump-sum settlement in the amount of ten times the annual pension instead of a regular pension in the event of an insured event. The provident fund informed the beneficiary that her monthly retirement pension would amount to around EUR 1,000 and that the entitlement would be replaced by a one-off payment of around EUR 123,000 in accordance with the proviso. The beneficiary objected to the one-off payment and transferred the money back. The fund wanted to establish that it was entitled to replace the pension entitlements with a one-off payment. The BAG rejected the complaint. The decisive factor was that the clause did not contain a debt of choice, but rather a power of substitution and as such is to be measured against Section 308 No. 4 BGB, among other things. The court found that the interests of both parties in a change to the service or its immutability must be weighed up in the context of reasonableness. Replacing the current retirement pension with a one-off lump-sum payment for only ten years would clearly fall short of the cash value of the promised retirement provision. The beneficiary would not receive another benefit of equal value, but one of lesser value. The clause was therefore invalid.

Interim conclusion: If the specific legal basis of the pension commitment grants a party a special right according to which the type of benefit is determined, it must be determined whether this is an elective liability (“either X or Y”) or a right of substitution (“X instead of Y”). Only the genuine optional debt between promised main services remains free of GTC control. In the context of substitution, it should be noted that reservations of change in general terms and conditions are invalid in accordance with Section 308 No. 4 BGB, which grant the user the right to change or deviate from the promised service if this is unreasonable for the other party to the contract.

Determination of the equivalence of the capital benefit based on which parameters

In the legal dispute 3 AZR 501/21, the employer had reserved the right to replace promised lifelong pensions with a one-off lump-sum payment equivalent to the present value. According to the specific commitment, the amount of the one-off capital payment should correspond to the cash value of the future pension claims and pension entitlements, determined according to the calculation principles of the actuarial report on the amount of the pension provision permitted for income tax purposes in accordance with Section 6a EStG as at the last balance sheet date before the payment. The BAG clarified that a substitution corresponds to equitable discretion within the meaning of Section 15 BGB if the interests of the pension debtor in the capital payment outweigh the interests of the pension recipient in retaining the pension benefit. The BAG did not decide whether the prescribed calculation method led to economic disadvantages for the pension recipient. The case was referred back to the Higher Labor Court for further proceedings.

Interim conclusion: In addition to other valuation factors, the actuarial interest rate is therefore a key component in the calculation of the capital payment. It contains the assumption as to what return can be achieved in the following years with the capital paid out. The benefit amounts therefore depend largely on the actuarial interest rate used. A higher actuarial interest rate leads to a lower actual cash value of the capital payment.

In principle, the employer is free to choose the actuarial interest rate for calculating the capital payment. Due to the long terms, an actuarial interest rate that is independent of fluctuations in value is advisable in order to avoid major differences between the capital payouts at different points in time. There are various approaches to determining the actuarial interest rate. For example, the actuarial interest rate in accordance with Section 6a EstG, which does not, however, take into account salary and inflation trends, the actuarial interest rates for the appropriate endowment of pensioner companies, actuarial interest rates from the German Commercial Code, international accounting standards, actuarial interest rates in accordance with the actuarial reserve ordinance or special actuarial interest rates inherent in the commitment. The actuarial interest rate therefore varied from 0.25 percent to 6 percent depending on the approach. The calculation methodology has not yet been clarified. Further observation of case law is therefore necessary.

The question of how the BAG would decide if the clause had not been formulated as a power of substitution, but as a genuine elective obligation, and therefore did not have to be examined under GTC law, also remains unanswered.

It can also be concluded from the current rulings that the benefits do not have to be equal in value if the beneficiaries have a lump-sum option, as they are free to decide. In this case, however, the employer must provide information about the calculation factors. A conspicuous disproportion between the pension benefit and the lump-sum payment is likely to be legally inadmissible.

Conclusion

The requirements for the capitalization option and the right of substitution and the questions of converting pensions into capital will continue to accompany us in practice. Particularly in times of high inflation, the value of the occupational pension scheme in dynamically securing the standard of living of pension beneficiaries became clear. If the employer does not wish to bear this financial risk of further monetary development and longevity, it must already regulate this when structuring its commitment. If he has only agreed an elective liability or a right of substitution, he cannot escape his pension obligation per se by making a one-off payment. This requires a well-considered, precise examination of all the circumstances of the specific individual case, taking into account the interests of the beneficiaries. In view of the burden of presentation and proof in the event of any subsequent judicial review, it is advisable to carefully document these considerations regarding the interests and value of the service.