Think about an investment product for your retirement. Pension plans are surely among the first options that come to mind, and it’s no coincidence.
For years they have been the leading tool for retirement and retirement planning. Do you want to know why? That is precisely what we are going to look at in this article, where we will tell you what a pension plan is, how it really works and what its advantages and disadvantages are. So you can decide whether or not it fits into your strategy, or how it can complement your investments.
What is a pension plan?
A pension plan is a long-term investment tool, initially designed for retirement. This is one of the main features of this product, but not the only one.
Another defining feature of pension plans is that you do not invest on your own. A plan is a collective pension and investment product that brings together many people’s money to invest it and thereby obtain certain advantages, such as access to professional managers or lower investment costs.
From a technical point of view, a pension plan is the shell of a pension fund, like its packaging. In the end, the plan invests your money in the pension fund, allocating the capital to a well-diversified portfolio of assets.
Types of pension plans
There are several types of pension plans and ways to classify them. They can be identified according to what the plan invests in, who created it and for whom, and how the inputs and subsequent benefits (plan redemption) are organized.
The first of these is the most typical distinction and is where we find variable income plans, mixed variable income, mixed fixed income, long-term fixed income, short-term fixed income and the famous guaranteed plans.
Categories ordered from highest to lowest risk
|Variable Income||75% of the investment is in variable income products|
|Mixed Variable Income||Between 30% and 75% of the investment is in variable income products|
|Mixed Fixed Income||The investment in variable income products may not exceed 30%|
|Long-Term Fixed Income||The investments do not include variable income products or derivatives that are not fixed income. The portfolio must be held for more than two years|
|Short-Term Fixed Income||The investments do not include variable income products or derivatives that are not fixed income. The portfolio can be held for less than two years|
|Guaranteed||There is an external performance guarantee and the invested money is guaranteed|
By type of contribution, we can distinguish defined contribution plans and defined benefit plans.
The first ones establish a periodic contribution or investment without insuring the capital at the time of redeeming the plan. The latter guarantee the money that you will recover plus a revaluation. There is also a mixed modality.
Finally, the pension plan can also be differentiated according to who promotes it. In other words, who creates it and for whom it is intended. This is perhaps the division that makes the most sense as a starting point. This is where we differentiate between:
- Individual pension plans, which is what everyone understands by a pension plan. These are plans that can be freely taken out on an individual basis at any financial institution.
- Employment pension plans, which are plans created or promoted by companies for their employees. These plans are only available to the employees of that company, and it is normally the company that contributes to the plan, which will be taxed as earned income for the employees. In many cases, the employees also make individual contributions which complement those made by the company.
- Associated pension plans, which are those promoted by unions and associations for their members.
How does a pension plan work?
Pension plans work in a fairly straightforward way. The first thing you need to know to understand them properly is to be aware of the figures involved in them:
- The person who invests in the plan, or the participant.
- The plan promoter, who is the one that creates the plan to market it.
- The manager, who is in charge of investing the money through the pension fund.
- The person who will receive the money, in other words, the beneficiary. Normally this beneficiary is you, but plans can be created in the name of other people and you can always designate the beneficiary of your choice to collect the money in the event of your death.
With this in mind, the process of investing in a plan is very simple. You choose the one that suits your needs, and you make your contribution, which is limited by law. The fund manager receives that money and invests it according to the plan’s policy. If all goes well, the money in the plan will increase.
What happens if you want to change plans? You can transfer your money to another plan whenever you want and at no cost. In fact, it is typical to change your plan throughout your life to adapt it to your circumstances.
Finally, the time will come to recover the money in the pension plan or capitalize the investment. Unlike other products, with a pension plan you will not be able to access your money whenever you want, although we will explain this in detail later.
Advantages of pension plans
A pension plan is defined by its characteristics and these are closely linked to its advantages. You may have heard about the fiscal advantage of plans when it comes to paying less taxes.
But that is only one of their positive features. These are the most important.
– You are able to diversify your portfolio
A pension fund can invest in many assets, from equities to fixed income products. And all for a very low cost: that of one share.
What 100 euros can do through a pension plan, would require thousands of euros to set up if you bought the shares on your own. That is why a pension plan is a diversified product at an affordable price.
If you are not clear about what diversification consists of, you can find more information here: the importance of diversifying your investments to reduce risk.
– They are managed by professionals
Behind every pension plan there is a team of expert investment managers. These professionals are in charge of making your money grow and deciding where, when and how the contributions you make are invested.
– They’re safe
Pension plans are regulated and under the supervision of the Directorate General of Insurance and Pension Funds (DGSFP, or Dirección General de Seguros y Fondos de Pensiones in Spanish), which offers many guarantees to participants.
– And they are also very flexible
There are pension plans for all tastes and investment profiles, both the most conservative and the riskiest. In addition to having a choice, you will be able to adapt the pension plan you have taken out to each moment of your life and the risk appropriate to that particular time.
– Transfers are free of charge
It also helps that you can change your plan as many times as you want without having to pay a single euro. The only exception is if you have received a bonus for taking out the plan as this includes a minimum term with a penalty if you break it.
– You can choose a beneficiary in the event of death
One of the characteristics that plans share with savings insurance is that you decide who inherits the money in the event of death. With other products such as investment funds this does not happen, the heirs are those defined by law.
– They allow you to pay less tax and get tax benefits
Later we will talk in detail about the key fiscal aspects of pension plans. For the time being, it is enough to point out that this product has an interesting tax benefit: the money you invest is subtracted from your tax base in the income tax return.
This means that you will pay less tax on your investments. To make this clearer, if you earn 25,000 euros a year and invest 1,500 euros in your pension plan, that amount will be subtracted from your salary in your tax return and for the Treasury it will be as if you had only earned 23,500 euros.
When you recover the money from the plan, the capital will be taxed as savings income, although if you do your calculations right, you will have an interesting tax gain due to the difference between the maximum rate you pay when you contribute and the one you pay when you get the money back.
Disadvantages of pension plans
As with any investment product, pension plans are a tool with a lot of potential pitfalls. These are the main negative points:
– Very limited liquidity
One of the characteristics of a pension plan is that you will only be able to recover your money in certain cases. The most typical is retirement, but it is not the only scenario.
Other reasons to get the money from your pension plan back early are:
- Total and permanent work incapacity for your normal profession, or absolute incapacity or severe disability in terms of being able to work.
- Serious illness.
- Death of the participant, in which case the plan may be redeemed by the beneficiaries or heirs.
- Long-term unemployment.
- Partial retirement, but only if the pension plan explicitly includes this.
- Early retirement, but only if the pension plan explicitly includes this.
In addition, from 2025 you will be able to access the plan without any restrictions or explanations from the tenth year of the investment. In other words, with a pension plan your money will be locked in for at least 10 years (barring unfortunate circumstances such as those described above).
The positive side is that your money will be out of your reach and you won’t be able to spend it, even if you are tempted to do so. This way you will avoid using your long-term retirement money for other things.
– You can lose money
With the exception of guaranteed pension plans, you will always be subject to market risk. In other words, you can lose money, as with any other investment, although this does not usually happen.
– You have to know how to choose
There are many pension plans to choose from, and not all plans are the same. It is important to choose one that suits your goals and investment profile. Later on, you should also adjust the plan to the market and to your own evolution.
Your needs are not the same when you are 20 years old as when you are 55, nor should the risk you take with your investments be the same. This means that a plan which is suitable for the first profile may not be suitable for the second.
– There are limits to investment in plans
The limits for pension plan contributions were modified in 2022. As a general rule you will not be able to invest more than 1,500 euros in an individual plan per year. To this amount you can add up to 8,500 euros of investment in a company pension plan.
In total, you will not be able to invest more than 10,000 euros in this type of product.
– Be careful when it comes to redemption
When you recover the money from your pension plan, you will be able to choose between different options, and not all of them involve the same taxes. In fact, a very common mistake is to opt for the formula that gives you the most money instantly, but that is also usually the most expensive in terms of income tax.
This is an added difficulty that you will not find in other products such as mutual funds or Unit Linked products, for example.
The tax key to pension plans
Taxes are a defining part of any pension plan. On the one hand, your contributions will mean you pay less income tax each year, but on the other hand, you must be careful when you get the money back if you do not want to pay more than what was actually deducted.
With regard to contributions, we have already seen that what you invest is deducted from your taxable income (something like the income from work and any other income you receive), up to a maximum of the amount contributed (generally, 1,500 euros in individual plans and 8,500 euros in employment or associated plans), or 30% of that taxable income, whichever is less.
Once this reduction has been applied, the rate corresponding to your personal income tax bracket should be used to calculate the tax savings you will achieve with your pension plan inputs.
As personal income tax is progressive, the higher your taxable income, the more money you will save. This is the table that applies to the general base:
|Income tax brackets||Type to apply|
|From €12,450 to €20,200||24%|
|From €20,200 to €35,200||30%|
|From €35,200 to €60,000||37%|
|From €60,000 to €300,000||45%|
|More than €300,000||47%|
As an example, suppose your tax base is €20,000 and you contribute €1,500 to an individual pension plan. Originally, a tax rate of 24% would be applied to your tax base, and you would therefore have to pay €4,800. However, with the reduction applied for your contributions to the plan, your tax base would become €18,500, and you would therefore have to pay €4,440.
If we do the same exercise using an employment or associated pension plan, and you contribute the maximum legal amount (€8,500), the reduction to be applied will be €6,000, which corresponds to 30% of your tax base. In this case you would only have to pay €3,360.
It should also be borne in mind that contributions to different types of pension plans are complementary, in other words, you can contribute €1,500 to an individual plan and €8,500 to an occupational or associate plan, making a total contribution of €10,000.
In exchange for this advantage, the money in the pension plan is always taxed as earned income according to the general personal income tax base and not the savings base, as is the case with investment funds or shares, for example. The reason for this is that if it was first used to reduce the taxable base, it is logical that it should then be taxed within the taxable base and not the savings base.
How is the redemption of the pension plan taxed?
But the true tax key to a pension plan lies in its redemption. How you withdraw the money determines whether or not your contributions help you save taxes in the long run.
The general rule is to determine whether there is a tax gain compared to the maximum rate (marginal rate) at which you deducted the contributions, compared to the maximum rate you will pay when you get your money back.
For example, if your taxable base is 40,000 euros when you invest, the marginal rate will be 37%, whereas, if when you get it back after retirement your income is 30,000 euros, the rate will be 30% and you will have obtained a tax benefit of 7 points.
This return will be in addition to the yield obtained by the pension plan through its investments.
To achieve this yield, the most important thing is to choose the right recovery formula so that you pay less tax. The tax authorities allow you to retrieve the benefits of the plan in three ways:
- As income, whereby you will receive a portion of the accumulated money on a regular basis.
- As capital, whereby you will receive all the accumulated money or a large part of it all at once.
- In a mixed way, which normally consists of an initial sum in the form of capital and then an annuity.
If you choose to recover the money as capital, you will be able to enjoy a 40% reduction on the amounts contributed up to December 31, 2006. Therefore, if by that date you had invested 100,000 euros in the plan, only 60,000 euros will be taken into account when calculating how much tax you have to pay.
To be able to apply this benefit, you will have to activate it either in the year you redeem the plan or in the two following years.
In this sense, withdrawing the plan within the financial year you retire is usually a bad idea. That is because your salary as an employee will be higher than your public pension and you will end up paying more taxes.
When you file your income tax return as a pensioner, your private pension plan will be added to the public pension and the two will be taxed according to the table we have shown you.
By way of example, if your pension is 15,225 euros (the average in Spain in 2022) and you withdraw 100,000 euros from the plan in the form of capital, even with the 40% reduction, your taxable income will be close to 70,000 euros. You will have to pay the tax authorities 45% of the 10,000 euros that are in the penultimate tax bracket.
If, on the other hand, you plan ahead and withdraw 90,000 euros instead of 100,000 euros you greatly limit the taxes you will have to pay. Better still, you could think about getting the money in the form of an annuity that optimizes the taxes you pay each year.
Are they worth it?
This is the million dollar question. Few products except cryptocurrencies are as controversial as pension plans, with their legions of supporters and detractors. The truth is that a pension plan can complement your retirement planning providing you with a long-term investment and a double return: that of the plan itself and the tax benefit.
But with the current investment cap of 1,500 euros per participant for individual plans, these have become a complementary alternative rather than the main tool for planning your retirement. In other words, now more than ever you should be looking for other investment products to help you meet your goals.