Where Can I Get the Highest Pension? Is the European Pension, 3rd Pillar, or Intelligent Investing the Best?
The European Pension is a fresh competition to the Slovak 3rd pillar. It represents a cheaper and more efficient solution. On the other hand, it lacks state support. Which of the parameters prevails, leading to a higher pension? Which is the best option for retirement savings, the European pension or the 3rd pillar? We have done the calculations for you.
After many years, the still waters of supplementary pension savings have been stirred up. A healthy competition to the 3rd pillar, an oligopolistic industry with immense regulatory barriers to entry, has emerged, which will ultimately benefit the savers. And it’s not just any competition.
The challenger is the pan-European Personal Pension Product devised by the European Union. Thanks to Finax, Slovaks are the first Europeans who can benefit from it via the European Pension investment product.
The range of pension alternatives in Slovakia has expanded. Each of the options has its pros and cons. Juraj Hrbatý has recently compared the advantages and disadvantages of using the Finax European Pension, the 3rd pillar, and Finax Intelligent Investing to save for retirement.
One of these pension products is cheaper, the second is tax-free, and the third benefits from employer contributions.
Which Pension Solution to Opt for?
The most important factor when choosing a financial product is the potential result, in this case, the pension we can get from each solution. That's why we've calculated the expected returns from the three basic supplementary pension savings solutions.
We have tried to be as objective as possible. Therefore, we have only taken into account the different expense ratios, varying tax regimes, levy advantages, and payout phase setups when making the comparison. The other parameters have been set equal for all three solutions.
We have assumed a gross before-fee portfolio return of 8% per year during the savings phase for all three solutions (the European Pension, 3rd pillar, and Intelligent Investing). The returns used in the calculations are illustrative, and they neither account for the historical performance of the investment instruments nor forecast future returns.
Except for minor differences, all three products currently offer passive investing via index funds, reflecting the performance of global equity markets (e.g., the MSCI World or MSCI All Countries World indices).
By assigning equal returns to all products, we can highlight the impact of fees, different tax and levy reliefs, and varying payout phases on the potential appreciation of pension savings, which, in turn, determines the resulting amount of pension benefits.
Unfortunately, most savers in the 3rd pillar are still not concerned about their wealth and invest too conservatively, depriving themselves of a significant part of their potential future pension. Nevertheless, they have the opportunity to appreciate their savings more efficiently, which is why, for the purposes of this article, we ignore the actual allocation of savings in the 3rd pillar and calculate the potential return of index funds.
The table above lists the valuation of the largest contributory fund of each of the four supplementary pension companies operating in Slovakia. In total, €1.54 billion is invested in these four funds, representing roughly 54.4% of all 3-pillar savings (as of 30.09.2022).
The average annual appreciation since the inception of these funds lags far behind inflation (and even further behind the 8% per year from our calculations).
For comparison, we also list the modeled performance of the Finax 100/0 and 80/20 portfolios, both of which form the investment strategy of the European Pension’s saving phase, and the Finax 60/40 portfolio, which constitutes the European Pension’s payout phase in phased drawdowns.
Please note: Investment returns are not guaranteed. Investing is risky, and investment may result in a loss. Learn about therisks you take when investing. All information related to the historical performance of the Finax portfolios is modeled and generated by data backtesting, the method we described in Howwe model the historical performance of portfolios.
We constructed the comparison using the example of a 34-year-old who will be depositing €100 per month into a pension product for 30 years. She will retire at age 64 to draw a monthly pension for 20 years.
The European pension benefits will be drawn gradually, the 3rd pillar savings will be paid out in the form of a temporary supplementary pension, and in the case of Intelligent Investing, our subject will draw the built-up wealth via an Intelligent Annuity.
In all three products, the pension benefit amount is calculated to draw the savings fully over 20 years, taking into account performance and fees in the payout phase. In the case of the European Pension and the Intelligent Annuity, we assume a gross appreciation of 6% per year (Finax 60/40 portfolio); the annual return assigned to the 3rd pillar’s payout phase is 3% before fees.
In reality, the pension will be lower given the same amount of savings as the provider has to expect non-linear portfolio appreciation, account for negative financial market scenarios, and keep certain reserves.
Results of the Comparison: Own Contributions
The highest net monthly pension (after income tax), assuming the only deposits are the saver’s own contributions, would be obtained from the European Pension.
In this case, the annual deposits are higher by €34.2 compared to the Intelligent Investing deposits. This results from an annual tax saving thanks to the tax deduction of €180 that can be claimed on own contributions to the European Pension or the 3rd pillar. If the saver does not deposit these saved funds into the European Pension, the final monthly pension will decline to €690.
Given these saving parameters, the European Pension’s lower fee and the tax base reduction compensate for the tax exemption of the Intelligent Investing returns. The latter would yield a slightly lower pension.
Our model saver would receive the lowest pension if she opted for the 3rd pillar. This is due to the highest fees during the saving phase, the low appreciation of savings in the payout phase, and the taxation of benefits.
The 3rd pillar currently offers a relatively wide range of drawdown options. As we were interested in a regular pension and the comparability of alternatives, we used a temporary supplementary pension where the saver sets the horizon for receiving benefits from the payout fund.
Savers can also draw the regular 3rd pillar pension through a lifetime supplementary pension – an annuity from an insurance company. However, the annuity is the most expensive pension payment solution with very high margins and low transparency.
This setting is only worth it if the saver lives a truly long life, which none of us can predict. The annuity’s disadvantage is the lack of inheritability since the saver has transferred the savings to an insurance company and used them to buy a lifetime pension.
In contrast, the account value of a pensioner's European Pension, 3rd-pillar temporary pension, and Intelligent Annuity is fully inheritable, as the saver still owns the savings.
On the other hand, the annuity provides some protection against significant volatility in the value of savings due to developments in the financial markets or against long-term insufficient appreciation of savings which, in extreme cases, could lead to an inability to pay out the agreed pension.
Will Advantaged Employer Contributions to the 3rd Pillar Change the Outcome?
The biggest advantage of the 3rd pillar is employer contributions, a popular employee benefit. Employer contributions into the 3rd pillar of up to 6% of a worker's gross salary are a tax expense and are exempt from levies into the Social Insurance Agency.
Unfortunately, employer contributions to the pan-European Personal Pension Product were not granted this benefit by the legislators. Hence, contributions must represent a part of the gross salary in the form of payroll deductions. Consequently, they are subject to social security levies, health insurance, and income tax. The same applies to Intelligent Investing.
Thus, one euro of employer contributions to supplementary pension savings in the 3rd pillar means a larger net contribution to the saver's account than in the case of the European Pension or Intelligent Investing.
What impact does this advantage have on the resulting pension, given the same employer cost?
We have assumed an employer cost of €192.74 (cost of labor). In the case of the European Pension and Intelligent Investing, the saver will receive €100 (net pay) of that amount. The net benefit received by the employee rises to €136.25 in the case of the 3rd pillar.
The table makes it clear that the larger employer contributions help the 3rd-pillar pension partially match the result of the European Pension and the Annuity.
However, even the contribution advantage does not compensate for the lower cost and better-performing payout phase of the European Pension and Intelligent Investing. Both of these options would still grant the saver a higher pension.
A Recommendation to Conclude
I can say with a clear conscience that the European Pension is a modern and efficient supplementary pension product that our ossified 3rd pillar truly needed. The European Pension has earned this title despite the handicap from our politicians.
It is a European solution with low costs and a greater degree of legislative certainty. Its huge benefit is the high transparency and easy comparability of different PEPP products with each other (thanks to a comprehensive and easy-to-understand key information document).
Unfortunately, in Slovakia, much to the detriment of future pensioners, it has not received any motivating state benefits even at the level of direct investment in securities traded on regulated markets (except for the possibility to deduct own contributions of up to 180 euros per year from the tax base).
Nevertheless, as the results have shown, it represents a healthy, needed and very promising competition to the existing supplementary pension saving solution. Its return potential is considerably higher, thanks to its significantly lower costs, more appropriate risk profile, and the more profitable payout phase.
I believe that most employers will realize this fact and provide their employees with a more attractive supplementary pension solution that will bring them higher pensions.
Direct investing, Finax Intelligent Investing, remains the most interesting form of retirement saving thanks to the tax exemption for Slovak residents applicable after one year of holding ETFs.
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The prohibition of retroactivity when changing tax laws represents a certainty of permanent tax exemption of returns on investments made before any change in the law. Consequently, today’s savers in Intelligent Investing can be certain that returns on their money invested before the law changes will remain exempt from the income tax and health levies.
Retirement savings are likely to reach a large value in the future. Thus, tax exemptions can change the outcome substantially (a one-third difference in terms of returns).
Leaving the taxation of the European Pension benefits in the hands of national legislators poses some risk since a possible change in the withholding tax rate would also affect the taxation of future pensions drawn from the pan-European Personal Pension Product (PEPP).
Another advantage of Intelligent Investing is that savings aren’t tied up – they can be withdrawn at any time, including in the event of extraordinary life events or early retirement.
However, this advantage can become a disadvantage for many savers. Tying up savings in a European Pension until retirement age makes them protected from the saver. He or she will not withdraw it to buy a new car, go on a holiday, or renovate a property.
What's more, in the long run, the fees of Intelligent Investing will be gradually decreased, making it even more attractive.
Unless the 3rd pillar reduces its fees and politicians modify its payout phase, it will remain interesting only for those employees whose employer offers it as a benefit and, for some reason, refuses to contribute to the pan-European Personal Pension Product.
All the experts agree that the pension system financed on an ongoing basis (1st pillar) is unsustainable due to Slovakia's demographics, the state of the economy, and the public debt. Supplementary pension schemes appear to be the most effective solution. However, a massive challenge is to bring savers with relevant regular deposits into supplementary schemes.
A pan-European personal pension product finally brings the necessary wind and vital competition to the field, which is essential to improve the quality of services and increase society's interest in taking care of its retirement.
I believe that the need for a proper supplementary solution will also be understood by politicians. I hope that the pan-European Personal Pension Product will receive proper support from the state to make us more motivated to rely primarily on ourselves when it comes to pensions, relieving the state of the dependence of future generations on its budget.