Thinking about the future

Reasons for saving

You can not think about your future equity if you have not previously made a good approach to your savings and all of your investments.

One way of internalizing the need to save is to analyze the ability of the Social Security to meet the needs of citizens in terms of retirement, unemployment, serious illness and long life.

The contributions that each citizen makes to the Social Security on their own account and through their employer are:

Exemple:

A worker earns 40,000 gross per year. For the company, the cost of salary is 51,960 euros. The difference, i.e. the 11,960 euros, is paid by the company into the Social Security. On the other hand, the employee pays 6.35% of their salary, i.e. 2,540 euros. Altogether a worker who receives a gross annual salary of 40,000 euros, brings 14,500 to the Social Security system.

Imagine a scenario without inflation or salary increases in a very simple simulation. In this case, considering entry to the working world at 25 and retirement at 65 after 40 years contributing to the Social Security, the person could theoretically receive an annual pension of 40,000 euros gross for 14.5 years until the age of 80. This significantly adjusts the average life expectancy for the Spaniards, which stands at 82.2 years (as reported by the National Institute of Statistics updated in 2012).

However, the current contributions from workers are used to finance other items, including the pensions of current pensioners, unemployment benefits, sickness benefits and casualties and accidents, amongst others. The evolution of the Spanish population pyramid should also be added, which reflects an ageing population, adding more retirees receiving the benefits of Social Security from a smaller active population. This, in simplified form, shows the small current sustainability of the social security system, exacerbated by the current unemployment rate in Spain (which is around 25%), and whose services consume a large part of the agency's budget. Therefore, it would be naïve to think that when the time comes for retirement we can count on this income, at least in its entirety.

The reality of the system is:

  • What we receive as a Social Security pension is the result of the average traded over the past 25 years. If your salary has increased steadily, the pension you receive may be smaller than your last salary.
  • In addition, the Social Security establishes a maximum contribution. Therefore, the maximum pension would be below our salary.
  • Being a tax system, the current reversal of the population pyramid shows the need to find a solution to this.

This simple analysis serves to raise awareness to the need to save for ourselves, creating our own pension plan thinking of our future welfare. If we can also efficiently manage taxation in all these years as an active worker, we can create another source of income that will give us an added plus.

How to optimize investment in a pension plan

The four basic rules

Pension plans are an instrument of long-term savings. These are final savings to cover our needs for retirement income and/or similar situations.

To get the most out of this tool, it is very convenient to keep the following in mind:

1 - Start ASAP

Between 30 and 40 years is a good age to start saving with long-term objectives. If you can consistently save a small part of your income for 30 years, it may produce a sufficiently attractive final capital to supplement income at retirement age.

2 - Systematic and disciplined contributions

When it comes to investing, discipline in decision-making is one of the aspects that makes the difference. As this is long-term investment, its importance is even more relevant. Contributions to a pension plan must be disciplined and systematic, and if possible each month. In this way you can achieve a double objective:

  • Level and optimized income throughout one's life, and
  • Take advantage of the volatility of the financial markets.

If a single annual contribution is made to an Equity pension plan in December, it could be the case that the subscribed shares have a higher price than they have had at other times of year. This happens by seasonal and statistical effects that clearly show that the stock tends to rise at year end. Therefore, a single annual average contribution does not allow the investment to be optimized. If several contributions throughout the year, this beneficial effect is achieved.

3 - Optimize taxation properly

The great advantage of the pension plans over other collective investments is its taxation. But like any other investment, it must be managed properly.

The underlying idea is to know how to exploit the difference in the tax burden between when a person is active and after retirement, with lower incomes and, therefore, lower taxation. The following should be borne in mind in optimizing this tax benefit:

  • Make maximum tax contributions when the tax is high (the bonus can be up to 56%, for example in the case of Catalonia), and take advantage of tax benefits that can be derived from one's family situation (for spouse and members with disabilities).
  • Reinvest tax credits in savings products / complementary investment (thus parallel to a capital pension plan but with a different tax treatment when receiving benefits).
  • To optimize the taxation of benefits. The pension plan is not designed to charge capital at the time of retirement or to take risks (you can have savings products / complementary investment for this). The pension plan provides income to complement the public pension, in such a form, amount and time decided on the basis of taxation and needs.

4 - Manage the likely risk exposure of the pension plans and funds

Pension plans and funds, like mutual funds, in which investment can be in different asset classes according to the investment policy. The exposure of the different types of assets is a decision you must take depending on your age and risk profile.

To do this, you have the possibility of transfers between pension funds. It would be advisable to focus investment in pension funds on equities when you are young and many years from retirement, and as you get closer to retirement to invest through the transfer of vested rights.

Normally, Investment Managers have different pension funds to cover these strategies.

Manage savings

To efficiently invest our savings we must define our targets from the amount you want to have for a future event and the time available.

With this information we analyze the risks and characteristics of each type of investment to finally decide where to turn.

Look at the following table of results for systematic annual contributions to a pension fund. Preliminary considerations:

  • 3 different profiles are taken as a reference: a person who starts at 40, another at 50 and another at 60.
  • The contributions made are two different amounts: 10,000 per year to 5,000 per year.
  • It takes different taxation scenarios into account: a marginal income tax rate of 40%, 47% and 51%.
  • The amounts of tax returns that are deducted from tax payments are reinvested in additional fund investment.
  • The two products are capitalized based on a hypothetical real return (after inflation) of 3% a year until 67.

The end result is that at 67 two capitals have been buid up: one in a Pension Fund to complement the public pension, and another in an investment fund (with different savings income taxation).

A Systematic Contribution Pension Plan. The tax benefit is invested in an investment fund.

 

Preliminary considerations 
Contributions to the Pension Plan Eur 10,000 annual
Eur 5,000 annual
Retirement 67 years
Actual performance (nominal interest rate - inflation) 3%

  

AgeDetailExemple 1Exemple 2Exemple 3
  Annual contribution

5.000

10.000 10.000
  Annual Income 40.000 80.000 150.000
  Marginal income tax 40% 47% 51%
  Tax Credit  2.000 4.700 5.100 
         
40 Pension Fund 209.655 419.309 419.309
  Supplemental Investment Fund 83.862 197.075 213.848
         
 50 Pension Fund 112.072  224.144  224.144 
  Supplemental Investment Fund 44.829 105.348 114.315
         
 60 Pension Fund 39.462 78.923 78.923 

 

Supplemental Investment Fund 15.785 37.094 40.251 

Saving

Household savings (families)

The gross income of a family can be devoted to current consumption, future consumption and savings (through investment in financial assets accumulated periodically).

Gross savings include both those intended as financial assets allocated to real estate. If from this we subtract the necessary part of the mortgage payment, we get the net savings.

The distribution of income between consumption and savings depends on several factors such as the expected permanent income, net wealth (financial and otherwise), uncertainty about the future, the increase in interest rates (making consumption less attractive) conditions of lending by financial institutions and even increases in the government deficit ratio to increase their taxes.

Household savings presents a contrast to the economic cycle, i.e. they fall in expansions and increase during recessions.

According to the National Statistics Institute (INE), the saving rate of households and non-profit institutions fell 2.8 points 2012 to stand at 8.2% of disposable income, the lowest figure since the series started in 2000. Contracting resulted in lower gross income (-2.7%) and a slight increase in end consumption expenditure (0.2%).

The sharp fall in wages affecting the country is having an effect on household disposable income. Consequently, the ability to save and end consumption also suffer. This trend accelerated in the latter part of the year, highlighting the difficult economic situation of many Spanish families. In the last three months of 2012, the savings rate was thus 12.7%, higher than the full year, but not due to an increase in disposable income (a 4.2% fall, 7,835 million less than in the same quarter of the previous year), but rather the the larger effort of households to squeeze their ever-diminishing income.