Is the old-age pension a good investment?

If this study only influences a reader to save more and/or invest better, it's already been worth it

When faced with a complex problem with no apparent solution, but one that will not affect us in the short term, what tends to be our reaction? None – we pushed with our belly. What if solving the problem is vital to our livelihoods in old age? The answer remains.

The average Portuguese does not have savings allocated to retirement, and when they do, it is manifestly insufficient to meet their needs. EUROSTAT data show that Portuguese households have a Gross Savings Rate of 14%: 33% less than the European average and 53% less than Sweden, where households have the highest Gross Savings Rate in Europe.

It's easy to “point the finger” at potential responsible for the low savings rate:

– Low levels of financial literacy;
– Low family income;
– High direct and indirect tax burden;
– Low support (including tax incentives) for retirement savings;
– Little attractiveness of financial products aimed at saving for retirement;
- Laziness;
- Risk;
– Complexity;
– “The State old-age pension arrives/State support arrives”.

Let's focus on the last point, a belief that I believe is fundamentally wrong. To better analyze this issue, I created a model to calculate the Internal Rate of Return (IRR) of each euro that we pay to social security. Here are my conclusions:

1 – It is incredibly complex to calculate how much old-age pension we will receive

On the Social Security website, we can see the formula for calculating the old-age pension: Pension = (Total Revalued Annual Career Remuneration ÷ (Contribution Years x 14)) x Global Training Rate x Sustainability Factor.

My model needed 17 inputs (7 direct and 10 indirect) to calculate the Internal Rate of Return of the old-age pension. Professor Richard H. Taler, winner of the 2017 Nobel Prize for Economics, explains in the book “Nudge” how complexity is the enemy of saving and how creating an adequate, simple and automatic incentive system promotes good financial decisions. In contrast, in Sweden and the United Kingdom, the state old-age pension formula (first pillar) only has two inputs: Number of Years of Contributions x Annual Value.

2 – Given the uncertainty of knowing whether the old-age pension is enough to survive in retirement or not, the tendency is to do nothing and hope that it will be enough

One of the banners I fly in my professional life is “hope is not an investment strategy”. In previous articles on this topic of retirement and pension funds (may read here ou here), I wrote that one of the factors that leads to 1) high savings rates and 2) larger retirements in countries like Sweden and the UK, is knowing that the state pension, by itself, is manifestly insufficient to have adequate retirement.

As a result, taxpayers and companies are responsible for financing this income deficit in retirement, and the State contributes with tax incentives to savings.

2 – The Internal Rate of Return of the old-age pension is very low

If the reader received the following proposal: invest every month between 21.4% to 34.75% of their monthly salary in an annuity, which can only be accessed at 66 years and 6 months (you can access it before, but the penalties are very high), and which annual rate of return is between 1%-3% would you accept?

An investment with a higher rate of return would increase your disposable income in retirement. Historically, a diversified investment portfolio generates much more attractive returns over similar time horizons.

Analyzing a hypothetical case (1-A):

João started to pay for social security as an employee at the age of 21, having earned €12,000 a year in his first year of work. João's annual salary grows at a rate of 2%, he plans to retire at 66 years and 6 months and lives until 86 years of age.

Results 1-A:

– Last pre-retirement salary: €28,680.64 per year
– Total remuneration during the career: €862,712.52
– Total paid in social security contributions: €299,792.60
– Old-age pension: €21,302.57, a loss of €7,378.06 (26%) compared to pre-retirement salary
– Internal Rate of Return: 1.78%

Scenario 1-B: for health reasons, João stops working at 61, asks for early retirement at 63, but lives until he is 90 years old.

Results 1-B:

– Last pre-retirement salary: €26,496.48 per year
– Total remuneration during career: €751,320.27
– Total paid in social security contributions: €261,083.8
– Old-age pension: €9,077.20, a loss of €17,419,28 (66%) compared to pre-retirement salary
– Internal Rate of Return: 0.65%

Scenario 2-A and 2-B: Same as the previous scenarios, but João is self-employed (service provision) instead of an employee.

Results 2-A:

– Last pre-retirement salary: €28,680.64 per year
– Total remuneration during career: €862,712.52
– Total paid in social security contributions: €129,234.34
– Old-age pension: €21,302.57, a loss of €7,378.06 (26%) compared to pre-retirement salary
– Internal Rate of Return: 4.27%

Results 2-B:

– Last pre-retirement salary: €26,496.48 per year
– Total remuneration during career: €751,320.27
– Total paid in social security contributions: €112,547.78
– Old-age pension: €9,077.20, a loss of €17,419,28 (66%) compared to pre-retirement salary
– Internal Rate of Return: 3.04%

Conclusion? It is crucial that each individual invests in their financial literacy and starts saving and investing early on. Good savings rates, by themselves, are not enough to remove the specter of poverty in old age.

The true Social Security Internal Profitability Rate is not reflected in this study, as social security gives us much more than the old-age pension.

If this study only influences a reader to save more and/or invest better, it's already been worth it – good financial decisions are those we make today with the long-term in mind.

 


Author João Martins has a degree in Business Management and a postgraduate degree in Corporate Finance from the Faculty of Economics of the University of Algarve.
He is a trainee member of the Ordem dos Economistas and is passionate and enthusiastic about financial markets.
He is currently a financial consultant at Abacus Wealth Management, a company based in Quinta do Lago.
Algarvian for several generations, he considers himself lucky to have lived, studied and worked in the Algarve.
He emphasizes the fact that having a twin brother is one of his greatest wealth and privileges.

 


Note: article published under the protocol between the Sul Informação and the Algarve Delegation of the Order of Economists

 



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