All around the world pensions can be funded in three different manners:
A) Pillar 1: Governmental Pensions
- In some countries expats are obliged to participate in the National Social Security Services and acquire State Pension Claims. In other countries they can choose whether or not to participate and can even acquire additional rights due to a lack in the past.
- Regarding the desirability of participation it seems advisable to beforehand calculate the cost versus pension claim ratio. As these days the interest rate is historically low, this often makes participation expensive.
- The height of existing coverages can differ substantially per country. The coverage is for example rather modest in the U.S. and more elaborate in certain parts of Southern Europe.
- Regarding the UK and Brexit is relevant that it is not yet decided if UK expats who receive UK State Pensions while based in the EU will still receive annual indexation after Brexit implementation.
B) Pillar 2: Corporate Pensions
The nature of corporate pensions differs per continent/country. Essential issues are:
- Is participation voluntary or mandatory?
- Is the coverage individual or collective?
- Is the coverage standard or a special expat plan?
- Is the nature i.e. DB/DC/CDC/Hybride?
- Is there a maximum for the amount of pension earning wages?
- Is the next of kin coverage risk and/or capital based?
- In case of guaranteed pension claims, is there (un)conditional indexation?
- Does the employer finance the whole premium?
- Is there substantial tax benefit?
- Is there the possibility to invest additionally in case of tax benefit?
- Is it possible to transfer pension capital from or to another expat plan?
Even though corporate pension plans differ substantially on global level, there is a trend towards the decrease of guaranteed Defined Benefit (DB) plans and the increase of not guaranteed Defined Contribution (DC) plans. The latter often still combined with a guaranteed next of kin coverage before retirement age.
C) Pillar 3: Private Coverage
The most common private coverages all around the world are:
- Private life annuities
- Death risk insurances
- Investment plans
- Real estate and life based mortgages
- Bank savings
New EU Plan
In 2017 the EU proposed a new kind of private coverage: The Private European Pension Plan.
The idea is that as many countries have different corporate pension systems, it is wise to introduce a within the EU transferable private annuity plan. We will wait and see if this idea will materialize and if the cost/claim ratio is interesting.
Relevant issues to determine how desirable these coverages are:
- Is there a tax benefit?
- Is it possible to determine the profit/cost ratio?
- Is it difficult to judge the nature and content of these possibilities?
- Are advisors by law required to have a license?
- How is the reputation of each possibility?
It is in the interest of the expat to compare the after tax gain/cost ratio of the 3 pillars per residency.
There are several kind of pension plan systems:
A) DB: Defined Benefit
- These pension plans provide guaranteed pension terms at pension age. There is no investment/ interest rate risk. These plans often also have a conditional right to indexation in order to correct for inflation.
- DB can be based on the actual Annual Wages. In case it is based on the Final Wages every wages increase creates a substantial premium back services as it also works towards the past employment. These aspects make these plans extremely expensive as the interest rate is historically low.
- DB plans were popular in Europe but have as of 1995 often been exchanged rapidly for DC pension plans.
- It is expected that in the near future final wages DB systems will be prohibited in several countries.
B) DC: Defined Contribution
- These pension plans provide guaranteed amounts of pension premium. At pension age an annuity will have to be bought with the total pension capital. There are no guaranteed pension terms. There is a substantial investment risk until pension age and a substantial interest rate risk at pension age.
- The investment risk might be mitigated by good Life Cycle funds which automatically decrease the risk as the age increases.
- The costs and performance of investment funds are highly relevant for DC systems. In certain countries like Holland there are new totally IT based providers who excel in low costs and high flexibility.
- In certain countries like Germany a pure DC system is not allowed and there is a modest guarantee to protect participants.
- In certain countries like the UK it is as of 2015 allowed to completely drawdown the total capital as of age 55 and even have a 25% non-taxation.
- In certain countries like Holland it is allowed to within DC partially keep investing pension capital as of pension age. The risk profile has to focus on the period before and after pension age.
c) CDC: Collective Defined Contribution
- In this system with the DC guaranteed amount of pension premium guaranteed amounts of pension annuity are acquired. In case the premium is not sufficient to provide the desired amount of annuity, then the latter will be decreased to a lower and affordable level.
- It is called the best of both worlds but as the interest rate is currently historically low, one can wonder if the price for certainty is not (way) too high.
A hybrid system has DC/DB/CDC elements. A popular hybrid system is to have a DC system for the old age pension coverage and a DB system for the next of kin pension coverage.
E) Trend in Europe
The trend in Europe is towards more individual and DC based solutions.
Investments & Risks
The essence of pensions is the return on investment and risk ratio of many aspects.
- Which investment within Pillar 1-3 will provide the highest consecutive (after tax/costs) gain?
- Are there such possibilities in other countries with higher expected consecutive gain?
- Which of the Active/Passive/Index tracker/Life Cycle/Sustainable approach provides the highest consecutive (after tax/costs) gain and fits within the expat’s risk profile?
- Are the Life Cycle funds tailor-made to the personal risk approach?
- Too often funds focus on indeed low costs but not on the much more relevant expected consecutive height of the annual gain.
- Is the expected DC Old age pension capital sufficient with a low interest rate at retirement age?
- Have you discussed with your partner how high the net next of kin coverage should be for the next 5 years or until the youngest child reaches the age of 18?
- Has been provided for a fitting disability coverage?
- Does your planning take into account that tax regimes might change substantially?