Invest successfully in pension plans
Index of contents
1.- What are pension plans?
2.- Why were pension plans created?
3.- Types of pension plans
4.- Costs and commissions of the pension plans
5.- Operation of pension plans
6.- Security of pension plans
7.- Tax regulation of pension plans
8.- Advantages of pension plans
9.- Disadvantages of pension plans
10.- Fiscal effect: pension plans vs. investment funds
11.- Tips
12.- For which people are pension plans more favourable?
1.- What are pension plans?
A pension plan is nothing more than along-term savings and investment product that allows the investor to have extra money in retirement and also enjoys important tax advantages, as discussed below. It should be clarified that the"Pension plan" isIn facta pension fund wrapped in a fiscal, legal and legal framework. That is to say, it is like a painting, the painting is the one that has the value and is protected by a frame. Once the plan is contracted, the promoter or marketing entity will be in charge of investing the money in a pension fund, which is the vehicle they use to obtain profitability.
2.- Why were pension plans created?
The pension plans have the objective of providing extra money over the retirement pension that is obtained from the State. A very common question is: why do I want extra money? Isn't it worth it with all the contributions I've been making to Social Security throughout my working life? Well, to answer that question, you must first understand very basically how the pension system works. The public pension system in Spain and in many Latin American countries such as Argentina, Brazil, Cuba, Ecuador, Guatemala, Haiti, Honduras, Nicaragua, Paraguay and Venezuela, is a pay-as-you-go system, that is, current workers pay the pensions of current retirees. The sustainability of this system is based on the following variables:
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the number of active workers
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the number of pensioners and
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the amounts of both contributions and pensions
In a simplified way, for the public pension system to be sustainable there must be more active workers than the number of pensioners, that is, the continuity of the system has a strong dependence on the population pyramid.
In this article we briefly analyze these three variables in the particular case of Spain, but this can be applied to all the aforementioned countries that present similar symptoms. The following graph shows that the number of pensioners has increased, but this increase is not accompanied by an increase in the same proportion of active workers. The population trend therefore indicates that there will be more and more elderly people. If we add to this the excellent news that life expectancy is increasing and the not so good news of the decrease in the birth rate, the sustainability of this system can be questioned.
In addition, as we can see in the following graph, the amount of pensions is increasing. The evolution of wages in recent years means that new retirees have access to a higher average pension, since they have contributed for higher bases, while new workers, who enter the labor market, do so with lower wages. and therefore with lower contribution bases.
One of the countermeasures that have been taken to alleviate this problem in several European countries has been the gradual increase in the retirement age that has been applied since 2013. From 2027 it will be set at 67 years. This does not seem to have solved the problem in Spain. A clear example of this situation is demonstrated by the state of the Social Security Reserve Fund, a 'piggy bank' in which since the year 2000 the surplus of the Social Security system has been kept, but which for 9 years has has been declining because the system spends more than it receives, that is, active workers can no longer sustain public pensions on their own.
Source: Ministry of Employment and Social Security, www.epdata.es; own elaboration
From time to time the European Commission commissions a study of projections. Within this study there is a projection on the replacement rate of public pensions. The replacement rate is the percentage that the public retirement pension supposes on the salary received by an employee during his working life. The following graph shows the projection of the replacement rate of European pensions. In Spain it decreased from 78.7% in 2016 to 45% in 2070. Although many of us enter retirement age earlier, it can be seen that the trend is negative, not only in Spain, but in other countries Europeans, although more accentuated in Spain.
Source: The 2018 Aging Report: Economic & Budgetary Projections for the 28 EU Member States (2016-2070), May 2018
It is normal that in view of this scenario, current workers think that their standard of living in retirement based on their public pension is lower than expected and pension plans are considered as a possibility when it comes to supplementing retirement income.
3.- Types of pension plans
Basically there are two types of pension plans, thePension plan privateand theemployment pension plan. The latter is quite common in countries like the United States. This article deals only with private pension plans, which are the best known globally.
Within private pension plans there are also different types since not everyone has the same affinity for risk. The different types of pension plans depend on the assets in which the pension fund invests. The most common are the following:
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pension plansfixed rent, which invest 100% of the money in bonds and debt products, both state and corporate, in the long or short term.
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pension plansequities, which are plans that invest money mostly in company shares.
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Pension plansmixed, which invest part of the money in fixed income and part in equities
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Pension plansguaranteed, which are those in which profitability is assured. This is usually lower than in other pension plans, but this is the price to pay for having that security.
4.- Costs and commissions of the pension plans
Like all kinds of financial products, pension plans have costs and commissions.The costs are implicit to the pension fund and are subject to the assets where the money is invested, which as we have just seen can be bonds or shares or any other product.Then we have the management commissionon the one handand the depository commissionfor another. Traditionally, pension plans have always had high commissions, in fact in Spain, the government has already had to limit commissions on several occasions, in 2014 and 2018, because the profitability of pension plans was going down. in paying the commissions of said plans. The current legal maximums for the management fee depend on the type of plan. If it is fixed income it is 0.85%, if it is mixed income it is 1.30% and if it is variable income it is 1.50%. In turn, the limit established for the depository commission decreased to 0.20%.
This is a point to take into account, since costs and commissions reduce the profitability of the pension plan. For this reason, there are also indexed pension plans, which, by benefiting from more passive management, are much more efficient as they have much lower commissions, while offering high returns and which we will present later. Clicking on thislinkYou can see our comparison of the best indexed pension plans in Spain.
5.- Operation of pension plans
Every pension plan has two phases, the contribution phase and the redemption phase. The operation of pension plans in the contribution phase is very similar to that of investment funds. are madefree contributionswhat can they beperiodic or punctualto the pension plan. These contributions have a tax bonus that varies greatly from one country to another.
The capital saved in the pension plancan be redeemed in four different ways:
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The first isin the form of capital, that is, we withdraw all the capital from the pension plan at once
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The most common way isin the form of financial income, in which the amount and periodicity of redemption is decided by the investor
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Themixed formIt's a mix of the two above.
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And finallyin the form of a life annuity, which is the least common and consists of an insurer giving us a fixed income for life from our pension plan. As this type is not very common and depends a lot on the specifications of each insurer and the age of the insurer, we are not going to deal with it from now on in this article.
As its name indicates, the pension plan is a pension product, that is, retirement-oriented, and it is for this reason that theCapital deposited can only be redeemed in the event of certain contingencies:
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Logically, the main contingency is theretirement
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In certain countries, such asin Spain, you can also remove thosecontributions that are more than 10 years old.
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othermajor cause contingenciesthat allow redemption are:
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Death of the owner
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Total and permanent work disability
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Serious illness accredited with a medical certificate
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Long-term unemployment (over 12 months)
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severe dependency
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Eviction from habitual residence or foreclosure.
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And finally, due to the Coronavirus pandemic, a window has been opened so that people who have lost a large part of their income can redeem part of their contributions.
6.- Security of pension plans
As we have previously mentioned, pension plans are nothing more than a name used to market pension funds and these are duly regulated to guarantee the security of this investment for future retirees. In Spain, the body in charge of supervising pension funds is theGeneral Directorate of Insurance and Pension Funds (DGSFP), a body that reports to the Ministry of Economic Affairs and Digital Transformation.
The pension plans are under the umbrella of la
General Directorate of Insurance and Pension Funds (DGSFP)
But beware, this organismmonitors funds to ensure their safety, since they cannot risk losing the money of the contributors to the pension plan,but it does not guarantee its profitability, which can be as in any fund, both positive and negative.
7.- Tax regulation of pension plans
Pension plans in Spain have two phases, the contribution phase and the redemption phase. In the contribution phase there is a tax credit up to a certain limit.To make the most ofblisstax creditof the first phasewe can contribute to our pension plan the lesser of these amounts:
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€2,000 per year(except in the Basque Country and Navarra, which have a different limit respectively)either
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30% of the sum of net income from work and economic activitiesreceived individually in the exercise.
The limit that we can contribute is therefore the lesser of these amounts. However, if your spouse has income from work or economic activities of less than €8,000, you can additionally contribute €1,000 on their behalf. In the case of people with physical disabilities greater than 65% or mental disabilities greater than 33%, the limit is higher, €24,250 per year and their relatives can additionally contribute another €10,000 per year on behalf of that person. The limit of €24,250 is also valid for professional athletes.
As it is possible to contract several pension plans, it could be the case of exceeding the mentioned limit, in this case the excess can be deducted in the personal income tax return for the following five years.
The tax deduction works as follows: the amounts contributed annually to the pension plan can be deducted in the income statement, reducing the tax base and therefore offering significant tax savings that will depend on the marginal rate you have. For example, if you have an annual salary of €30,000 and you have contributed €1,000 that year to your pension plan, the total tax base to be declared will be €29,000.
It is VERY important to mention thatTaxes are not paid for contributions during the contribution phase, but taxes are paid during retirement when redeeming the capital savedin the pension plan. This means thatthe taxes you save in the contribution phase, you have to pay later during your retirement. This is calledtax deferral. Even so, this tax deferral can be beneficial since for most people, the personal income tax rate during retirement is usually lower than the personal income tax rate during the contribution phase, especially if a lot of money is collected in this phase. .
It is for this reason that if you redeem the entire pension plan in one year, that is, suddenly, the most likely thing is that the tax rate would skyrocket to the highest bracket (45% in the general tax), which would cancel the tax credit obtained in the contribution phase. However, if you have contributions prior to 12.31.2006, said contributionsThey have a 40% reduction if you make the redemption in the form of capital. In other words, for 40% of the contributions redeemed in the form of capital, no taxes are paid. That is why we do not recommend a bailout at once but depending on each person it may be advisable to do a mixed bailout, that is, part of the plan is bailed out at once to benefit from the 40% exemption and the other part of the plan in of rent.
Now, this reduction has two BUTs, the first is that there is a time limit to request it. If you have retired before 2015, you have a term of 8 years. Right now (2021) you can only request it if you retired in 2013 or 2014. For those who have retired since 2015, the term is 2 years. In this case, you still have time to request the reduction if you have retired in 2019 or later. The second BUT is that you can only apply once for each pension plan you have. You can request more redemptions in the form of principal over time and even within two years of retirement. However, for the following redemptions in the form of capital, you will not be able to apply the reduction and you will have to pay taxes on all the capital you redeem.
8.- Advantages of pension plans
fiscal benefits, explained above.
Since the capital cannot be withdrawn before 10 years, they are a kind ofpiggy bank for retirementto be able to save and not spend that money, especially for certain people who do not know how to manage their personal finances well and who have the risk of spending that money by the mere fact of seeing it in their checking account.
flexibility in contributions, since each investor can plan the amount and periodicity of their contributions to the pension plan (as long as the amount contributed does not exceed the annual maximum set by law).
is atotally passive investment for the investor, in which you will only have to take care of choosing the type of pension plan, that is, the type of assets in which the fund must invest and the managers take care of the rest.
flexibility in the form of ransom collectionand even on the date of collection, since it is not mandatory to redeem the capital just at the beginning of retirement, but it can be done later.
AretransferableJust like investment funds. In fact, they are transferable even if the pension plan invests in ETFs. We already saw in the video of the ETFs, that these, unlike investment funds, are not transferable, but if it is a pension fund that buys this class of assets, then they are indeed transferable.
exempt from wealth tax. This only applies to those people with high net worth, who are in Spain, the ones who pay this tax.
canto diversifyin different pension plans at the same time, as long as the limit stipulated in each country is not exceeded.
9.- Disadvantages of pension plans
lack of liquidity, since the capital of the pension plans is trapped at least until 10 years have elapsed since the first contribution, with the exception of the cases that we list in the first lesson of the course. As we have mentioned before, this can be seen as an inconvenience or as an advantage, since it is a kind of insurance against ourselves, which does not allow us to touch that money for at least 10 years.
We have to paytaxes on the entire capital redeemedand not only on the profit obtained as happens with investment funds.
Besides therescueof pension planspay taxas income from work and not as savings income for which they are subjectto the tax rate of earned incomewhich is generally higher than the savings tax rate.
Lastly, management costs are higher than if you manage your own investment or compared to other similar investment products, such as investment funds.
10.- Fiscal effect: pension plans vs. investment funds
You may be facing the dilemma of whether to invest in pension plans or investment funds. If you have any doubts as to which is the most costly for tax purposes, we are now going to compare the tax effect between investment funds and pension plans with a practical example of a person who has contributed to Social Security for 40 years. For itwe will set several variables:
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First of all we are going toignore inflation, since what we want is to compare both financial products andinflation affects both the one and the other equally.
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Second, the costs as well as thereturns of both products are identicalbecause they invest in the same financial assets. Let's assume that theaverage profitability after deducting the costs is 5% per year, which means approximately havingmultiplied by 7 the amount invested after 40 years.
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Third, in the example we will consider afixed salary of €30,000 per yearthat does not vary until retirement and of which every year€1,000 gross will be dedicated to the investment.
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Room,the retirement pension is 75% of the €30,000 and in each year of retirement he only redeems the capital corresponding to each year of investment, which as we have said before will have been multiplied by 7.
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And finally, fifth, we are going to suppose that thetax rates at retirement age have remained constant.
Now imagine that the different taxes are like swimming pools. On the one hand we have the pool of income from work and the pool of savings income.
During the working life, each year a tanker truck comes with the salary to fill the pool of work income and the shaded area of each pool is taxes. This shaded area changes in different countries and even within Spain, it changes within each Autonomous Community. Since we are not going to break down the taxes of each Community in this example, we are going to use the sections of the general tax. The unshaded area is the money after taxes, that is, our net.
In the case of the pension plans, I only fill the pool with €29,000, since the €1,000 to be invested in the pension plans are not taxed, with which they remain in the tanker truck that takes them to the special deposit of the pension plans. pensions and will be dumped into the pool at the time of rescue. In the case of investment funds, the tanker truck also fills the pool, but in this case with €30,000, since the €1,000 that we want to invest in investment funds are not tax-reduced and must be taxed first. We see that of the €30,000 we have €23,889 left, that is, taxes have taken an average of 20.37% of our salary. If we now use that percentage and apply it to our €1,000 that we want to invest, then we have €796.3 left to invest in investment funds. This is one of the main differences between the plans and the funds. In the plans, the €1,000 is tax-reduced and does not pay taxes in the contribution phase, since it is not poured into the pool. However, in the funds, the €1,000 does pay taxes, so we have less to invest.
We now move on to retirement age, which is when we want to make use of what we have invested. In the case of investment funds, the public pension, which is 75% of what we were previously receiving, that is, €22,500, fills the pool of earnings from work. But this pool is of little interest to us right now since the mutual fund's profits come in a separate tanker that goes to the equity returns pool. Be careful, the tanker truck contains only the profits obtained in the investment funds, which are the ones that are poured into the pool of capital returns and are taxed. The invested capital is not taxed, because it was already taxed in its day in the pool of work income. Since the amount invested has been multiplied by 7, the first €796.3 are the invested capital that is not taxed and six times €796.3, that is, €4,777.8 are the profits that are taxed. As they are less than €6,000 they are taxed at 19%. It can then be said that the €1,000 gross investment has generated a net €4,666.30 with this investment fund.
In the case of the pension plan, we will have the tanker truck with the public pension of €22,500 plus another tanker truck with the income from the pension plan, that is, the €7,000 that is taxed in the pool of earned income. The pool is then filled with €29,500, of which we are left with €23,539 after tax. Taxes have taken an average of 20.21%. The €7,000 of the pension plans remain at €5,585.30 after taxes.
In short, the €1,000 gross invested in investment funds have generated €4,666.30. While €1,000 gross invested in pension plans have generated €5,585.30. This is almost €1,000 more than investment funds.
11.- Tips
It is true that in this example we have set many variables and that in real life it is not always that simple, but regardless of this, the following 6 tips can be taken from this example.
1. The first is that if we choose pension plans that obtain similar or higher returns than mutual funds and the costs are also similar, then pension plans are a better choice. Pension plans with low costs and with returns similar to passive investment funds are those that invest in the same assets as said funds, that is, those that invest in ETFs and index funds. From here we can get our first tip: look for low cost pension plansand that they at least copy the profitability of the market.
2. We can also conclude that the redemption of the pension plan in the form of capital has a negative effect, since it would trigger the taxable base and we would pay a very high income tax tranche, possibly equal to or greater than 45%. The pension plan is not the right product if you want to rescue your money at once. From here we get our second tip: never bail out the pension plan at once.
3.If you have contributions prior to 2007,We advise you to redeem part of them in the form of capital and thus benefit from a 40% exemptionon that part redeemed in the form of capital.
4. The greater the tax difference between the contribution phase and the redemption phase, that is,the higher your salary during your working life, the greater the benefit you will obtain by investing in pension planscompared to investment funds, since the public pension will never reach the level of your salary. This benefit is diluted by low income and even if the costs of the pension plan are higher than those of the fund, it may still be more profitable to invest in mutual funds. In our personal opinion, if you have a salary below €25,000, we advise you to start investing in investment funds instead of pension plans, since the probability is low that investing in these will be more profitable for tax purposes. Our advice in the event that you have salaries of more than €30,000 is to try to make the most of the tax credit in the contribution stage.
5. Our next tip is titled,tax diversification. We don't know what taxes will be like in the future on the day we retire, but one thing is clear: pension plans will be taxed as income from work and investment funds will be taxed as income from capital. Investing in both offers a very interesting tax diversification.
6. The last piece of advice, although quite obvious, is very important:Without tax bonus, better to invest in investment funds. This applies when you have the possibility of investing more than the legally allowed limits, for example, more than €2,000 per year or also in case the government eliminates the tax credit in the future.
Seen as the current situation is and how the projections look, it seems obvious that we cannot trust public pensions.
From Explorador Financiero we recommend to those people with a medium-high salary contract at least one low-cost pension plan (for example, indexed pension plans -Compare the best indexed pension plans in Spain) para thus make the most of the €2,000 tax bonus and complement the pension plan with other financial products such as index investment funds or roboadvisors to achieve more financial goals in addition of a golden retirement.
12.- For which people are pension plans more favorable?
Thepeople for whom it is more favorable to invest their money in pension plansinstead of investment funds are:
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Theself employed, who usually contribute the minimum to Social Security, which implies that their public pension will be the minimum.
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People with high average salary
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People who plan in the future periods with little or no income, such as leave of absence, voluntary leave, sabbatical years.
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People who plan to have alow or non-existent rent in the rescue, so they will pay little or no taxes when they redeem their pension plan.
Thepeople, to whom it does not come to mindhiring a pension plan instead of an investment fund are:
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people withlow wages in the contribution phase
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People who plan to havehigh rentsfor work or economic activityin the rescue. Be careful, this also includes income from real estate rental.
Today there is a trick by which you can redeem up to €13,115 from the pension plan without paying a single euro in taxes, this amount may be higher depending on the personal circumstances of each one. This is possible due to tax deductions:
+ €5,550 as a minimum personal exemption for each taxpayer
+ €2,000 of deductible expenses when having income from work or financial activities and
+ €5,565 deduction for all income from work less than €13,115
13.115€
However, two conditions must be met:
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The first is not having other income other than income from work or economic activities except for the €13,115 per year redeemed from the pension plan.
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The second is not having income other than work, with the exception of exempt income, greater than €6,500.