In defense of funded pension schemes
#finance 5 min.
Lithuanian pension system rests on three pillars, a common structure over all of EU. The idea is to introduce some flexibility and spread the risk, instead of relying on a single system for financial security in the old age. First pillar is a state-run pension scheme, which is designed to just about keep you out of poverty. It is financed by taxes. Second and third pillars are voluntary, though highly encouraged using various policies and incentives. Both are fully funded, which means your contributions come out of your income and are then invested through private funds.
Funded pension systems don’t get much love in Lithuania. The terrible level of financial education doesn’t help, but even educated people often distrust, or at best see them as sub-par. I don’t share the sentiment. I truly believe that for most people it’s vastly better than doing nothing or even rolling your own investment plan.
With tax-funded schemes, you just kind of hope that when you get old there will still be someone left to pay taxes, which will then be redistributed to you as a monthly pension.
With fully funded schemes, your contributions remain yours and compound over the decades, so once you retire, you get to reap the tax-free rewards in the form of annuity.
I’m gonna list a few major benefits that people often overlook when considering 2nd and 3rd pillars. Keep in mind that I’m commenting on the Lithuanian system; I don’t know other countries that well, so do your own research. Still, at least some of these should sound familiar to most europeans.
Ease of use. You can setup your plan and contributions in one afternoon, then forget about it until retirement. You could automate a lot of alternatives too, but the amount of effort required doesn’t even compare. The fact that you don’t have to think about it means that you will not stress over market fluctuations, or try to time the market, pick stocks, switch funds every couple of years for no good reason, and make all the other common mistakes.
Incentives. Many governments want you to save for retirement so desperately that they will even pay you to do it. In Lithuania you can get up to 516 eur each year if you max out all incentives. The more you earn, the less this means to you, but hey, free money is always nice.
Tax efficiency. And often overlooked benefit, which is really just another incentive, but I felt it’s worth mentioning separately. Your employer can make contributions on your behalf of up to 25% of pre-tax salary - here’s a practical guide in lithuanian. That’s cool, but it gets even better - you will not pay any income tax on annuity once you start cashing out in the old age. Simply put, funded schemes are effectively tax-free, so you get a lot more bang for your buck.
Solid strategy. Pension funds are legally obliged to follow life-cycle strategy in Lithuania. It maximizes returns early in life and minimizes volatility closer to target retirement date. It has been proven to be effective. You could do a lot worse investing on your own.
Low fees. This of course depends heavily on your country. The law in Lithuania demands pension funds charge no more than 0,5/0,8% per year in management fees (depends on the type of fund), when most mutual funds charge 1-2%. As these funds grow larger, they might even start competing on price.
Security. Pensions funds are probably the most regulated investment products. Your money is definitely more secure in any pension fund than in some random fin-tech darling.
If your savings are in euros, then European Central Bank offers even more security - the government of your country can’t nationalize or write-off your savings using currency or bond manipulation. Here’s a couple of stories from Hungary and Poland.
The major perceived problem with 2nd pillar scheme in Lithuania is that once you agreed to it, you cannot stop contributing or cash out the money prior to retirement. I see how this doesn’t inspire confidence, but really, you should be doing exactly that anyway. Your retirement account isn’t your savings account. It only makes sense if you stick with it for multiple decades, so best if you forget about your contributions until it’s time to buy annuity.
Another problem is that each new government has bright new ideas how to reform the system. That definitely doesn’t inspire trust in it’s stability over the years, let alone decades. I don’t have any counterpoint to this; it really sucks. Systemic risks are a part of any investment strategy.
Funded pension schemes aren’t perfect, and they don’t have to be - they are designed to work just well enough for most people. If you’re currently not investing anything for your retirement, I would suggest reconsidering the voluntary pillars in your country. It’s a lot better than doing nothing, and you’re likely to do much worse on your own.
If you’re ready to take care of your future on your own, it’s definitely doable. Just be aware that it will take a lot more than some random real estate, bitcoin, and TSLA stock.