Pensions in a Nutshell

What Are We Even Talking About? 

A pension can be defined as a regular payment made by the state to people of or above the official retirement age and to some widows and disabled people. The pensions are paid out from several sources collectively called the pension savings.

The pension savings serve as a means to accumulate a portion of money earned in the productive age so that you can enjoy the well-deserved rest and comfortable retirement upon finishing your active career. According to how the money is accumulated, we divide the savings into the pension pillars.   

Pay-As-You-Go Pension Savings, a.k.a. The I. Pillar

The pay-as-you-go system (PAYG) is what tends to spring to mind as first when we begin to talk about “pensions”. The system has been invented and implemented by Otto von Bismarck in the 19^th century and is a vital part of the pension savings to this day.

In this system, the working class contributes into the state treasury via social security levies. The collected money is then paid out in the form of pensions to the current retirees.  

So, they are paid out by the state, usually through a separate institution specifically established for this purpose. That’s why it’s also called the state pension. This means that the money saved in this manner does not accumulate over time, but is used to finance the pensions of the current retirees. In exchange, you will be eligible to have your pension paid for by the workers in the future.

The amount of your state pension is calculated based on a formula that is specific for each country. You should be able to find it on the website of your country’s relevant ministry.  

An important indicator is worth mentioning here: the ratio of the pension you will receive after retiring to the salary you used to earn in the productive age. This is often called the replacement rate, and it can be expressed as a percentage of the previous gross or net salary. In the EU the current average monthly gross salary is approximately 2858 €.

According to the European Commission Ageing Report for 2024, the current replacement rate in the EU stands at approximately 43%. Using this number, we can say that an average European's pension would be around 1229 € a month (before taxes).  

A Ticking Bomb of Demography – Downsides of the State Pension 

The system described above made perfect sense when it was invented back at the end of the 19^th century. Advancements in technology, most notably the discovery of industrial fertilizer, allowed for a population boom, creating a large future working class, which was able to support the existing retirees. States raised enough money on levies to be able to pay out sufficient pensions that ensured a decent retirement.  

I believe the problem begins to pop in the eye a little. In order for this system to function, more and more children need to be born so that they can support the generation of their parents. If a lot of children were born in the past, they have to have even more children of their own, so that their incomes will be sufficient to support a massive load of future retirees.

As the population pyramid depicts, the working class is going to shrink in the future, while the number of retirees is only going to grow. The bad news is that the Pay-as-you-go system will come under pressure due to this unfavorable demographic trend.

As of now, the share of old people (65+) in the population grew by over 3% over the course of the past 10 years, largely at the expense of the working class (15-64). Furthermore, the ratio between the future working class (so young people who are currently below 15) and the old people shrank from 0.84 to 0.70 over the same period. That means that nowadays there are around 70 young people per 100 old people, compared to 84 young people per 100 old people just 10 years ago.   

This will, therefore, lead to two possible outcomes: Either the levies used to finance the system increase, or the pensions decrease. Pensions are likely to either decrease or they won’t be able to keep pace with the increases of wages and prices.

Despite all the cons stated, the state still plays a crucial role in the whole pension system.

Pay-as-you-go pensions are vital when applying the solidarity principle. I.e. the richer and the wealthier contribute to pay for the pensions of the poorer and economically vulnerable, or those who did not earn that much during their career or were unemployed. 

Therefore, the state keeps and sets a certain social standard for the entire population, making it an important tool at combating poverty.

However, deciding to rely only on the state pension is definitely not a good idea. If you’re interested in how you can take care of your pension even with smaller amounts, read this blog.

The II. Pillar: Different Meaning – Same Objective 

Depending on the country or part of the EU, the II. Pillar as a concept is understood to mean two quite different things. Furthermore, some countries do not have either version of it. Let’s examine them a bit more closely:

Occupational Pension Savings – The Western Type 

You can imagine them like a pot of money set aside by you and your employer that grows over time to provide you with income when you retire. Think of it as a collective piggy bank where both you and your company contribute a portion of your salary which is automatically deducted.

This pot is then invested in various ways (for instance, in stocks or bonds), allowing it to grow over time. By the time you retire, this pot has ideally grown large enough to provide you with a steady income, supplementing any state or personal savings you might have. This should help you maintain a comfortable lifestyle even when you're not working.

What is important to note is that this that such scheme is often tied to being employed. If you decide to switch jobs, the savings can be transferred to the scheme of a different company, since the savings are your property and not company’s.

This kind of scheme is used mainly in the Western part of EU e.g. Austria, Italy, Netherlands or France.

There are two main types of occupational savings schemes:

1. Defined Benefit Plan (DB)

In this scheme, it is the benefit, that is determined beforehand, and the contributions are adjusted accordingly. For example, the benefit may state that you get 50€ a month per every work year. Assume you’ve worked for 40 years, so your monthly benefit will be 2000€.

It is the employer's responsibility to ensure that there is enough money in the fund, some allow you to contribute from your own pocket as well.

2. Defined Contribution Plan (DC) 

In this case it is the monthly contribution that is defined beforehand. The amount of the benefit paid out will depend on the result of the chosen investment strategy. For instance, if my monthly contribution is 100€ and your investment strategy yields an average 8% annual return, after 40 years you’re left with approximately 322,000€. Assume you will spend around 15 years in retirement. The monthly benefit will be approximately 1,790€.

The main threat in a defined contribution plan is selecting a sub-optimal investment strategy. When investing for goals like retirement, which are several decades away for most people, there is no reason to shy away from funds that track stock indexes (often referred to as index strategies in retirement planning), as those earn the highest long-run returns. We have discussed why stock indexes are the best long-run wealth-building tools in this blog.

In both cases, the money is pooled into your personal tax deferred account in an investment firm which manages pension funds. This company invests your money, allowing you to earn a certain return based on the chosen strategy. The contributions themselves are usually tax-exempt. However, the payouts are perceived as a form of income in many countries, and thus are taxed.

Funded Pension Savings – The Eastern Type 

As the name suggests, the second understanding of the II. Pillar's meaning is found mainly in the countries of the former Eastern bloc, such as Slovakia, Latvia, Romania, or Estonia.

Here, the contribution is not made by the employer nor comes from the employee’s pocket. The contribution is instead taken from the social security tax that you would normally pay.

For example, if the social security tax is 18% of gross income, which normally goes into the PAYG scheme, you may redirect a part of this contribution and it goes into your personal retirement account which you set up at a retirement fund management company, where the money gets invested and you earn a certain return, based on your investment strategy.

The downside is that you are not in charge of the amount of the contributions. The exact contribution rate is in the hands of the government.

However, a huge upside is that these contributions represent money that you would have to give up in favor of the government anyway. Therefore, it is practically free money.

Depending on the country, joining the scheme is either, mandatory (e.g. Croatia, Romania or Poland), or voluntary-automatic (e.g. Estonia or Slovakia).

All in all, the II. Pillar is a great tool at stabilizing the entire pension system and a great way to ensure comfortable retirement. However, it often does not suffice itself due to limits on contributions.

Voluntary Pension Savings a.k.a. the III. Pillar 

The third pillar is funded by voluntary contributions into your pension fund.

You have a complete control over the amount of the contribution as well as the fund or investment strategy where the money shall be appreciated.

What makes this kind of saving different from just investing money into an index fund or through a broker is that withdrawal is typically possible only upon reaching the retirement age (with some exceptions).

The nature of the third pillar again differs from country to country, but is highly connected with the II. Pillar.

Eastern Model

As we already talked in the previous segment, the employer does not contribute to the pension savings in the II. Pillar. Instead, the employer may decide to contribute into the employee's III. Pillar product.

Western Model

In the West, the III. Pillar takes the form of individual voluntary savings products. It is fully the employee’s responsibility to contribute into them, as the employer contributes into the II. Pillar.

The rules are set by the government, which can affect the fees, taxation, or transferability of these funds. Despite the government regulation, the charges are quite high all across EU with a few exceptions like Romania or Lithuania. Moreover, the investment strategies are often set unreasonably cautiously, with only a minor portion of the funds allocated to high-return stock index funds. That is why many people, despite having saved in these products for many years, have seen minimum returns on their contributions.

So, unless you are in one of the countries in the East of EU where you can get contributions from your employer, it is usually not really worth it to invest here, especially when you compare it with other products that can be used for the same purpose.

PEPP a.k.a. European III. Pillar 

Looking for an alternative to the ancient standard III. Pillar?

With the aim of unifying and simplifying the process of retirement preparation, the European Union has created its very first financial product: the Pan-European Pension Product (PEPP). Finax became the first European company to offer it as a part of its services.

This revolutionary product offers you protection. Not only from rising prices, low returns, or unreasonably high charges, but also from yourself, as you cannot withdraw the savings before retirement age. This prevents you from being tempted to spend it on other goals.

For more detailed information on the European Pension, visit its product page on our website. I believe most of your questions will be answered in the key PEPP documents on the 100/60 and 80/60 investment strategies.

Here Are a Few Reasons Why to Save for Retirement With PEPP

1. Appealing Returns 

The cornerstone of PEPP's investment strategy is made up of our classic Intelligent Investing portfolios, namely 100/0 and 80/20 portfolios (the numbers represent the ratio of stocks to bonds in the portfolio). This means that you can find all the elements which make the Intelligent Investing a high-return and low-risk product here as well.

The portfolios are broadly diversified, or in other words, divided among more than 7400 stocks and 6000 bonds across various sectors, countries, and firms. For more information on diversification, read this blog.

Moreover, the portfolios are automatically rebalanced on a regular basis. That means that we maintain the optimal ratio of the stocks to bonds within the investment strategy that was set at the beginning based on the client's specific situation, so that the composition and the risk level of the portfolio remain at a level reasonable to them.

What’s more, the PEPP's payout phase is built on a 60/40 strategy (60% stocks, 40% bonds), ensuring that the savings continue to be appreciated even in retirement, prolonging and increasing the paid-out pension. The fact that savings are often left to be eroded by inflation in retirement is a huge weakness of many national third pillar products.

2. Low Fees 

As I mentioned earlier, the main downside of the standard III. Pillar are the high fees. With PEPP, you only pay 0.72% a year.

You can find more on how significant the height of the fees is for the value of your portfolio in this blog.

3. Legislative stability and transferability

The rules of the game for the II. and III. Pillars tend to constantly change, whether it is the taxation, pension fund regulation, fees regulation, entrance conditions etc.

For the majority of savers, the legislative instability and state intervention often constitute major risk and downside. Stability and consistency is vital when investing for several decades.

PEPP beats this problem, as it is established by a unitary EU legislation, which is in effect in all 27 member states.

This also means that your employer can contribute to your personal account in whichever EU member state, and you may withdraw your money in whichever EU member state.

Getting Ready for Retirement by Investing Directly

The alternative to the III. Pillar is taking care of your pension on your own, by investing directly. It is the way which is the safest in terms of state intervention. Politicians cannot significantly alter how you invest, how much you invest, or with whom you invest. The only possible way to affect your investment is through tax policy.

In most countries, long-term investing into ETF funds, which form the backbone of our investment strategies, are usually tax-exempt. Therefore, if the saver is responsible and had saved for retirement throughout their entire life, they will manage to accumulate a significant pool of money by the time they wish to retire. Tax-exemption, therefore, can save them significant amounts.

As I already mentioned, investing into ETFs offers countless benefits, such as great returns, low fees, high efficiency, broadly diversified risk, simplicity, and the possibility to automate the entire process.

To sum it all up, everything that I’ve stated so far constitutes one significant truth. Nobody else is responsible for taking care of us, but ourselves. We are the only creators of our wealth and happiness. And the same goes for our retirement.

We live in times when we have a larger stock of opportunities to take care of our retirement than ever before. We may pick and choose the provider, form, tools, the amount, automation level, regulation etc.

So, let’s take the future into our own hands! No excuses.

Investing is associated with risk. Previous returns do not guarantee them in the future and the investment might end up in a loss. Stay informed on the risks you undergo when investing. 

The resources in PEPP are bound until the retirement age and early withdrawal is possible only under specific circumstances (full invalidity, disability etc.) 

Tax regime depends on the individual circumstances of each client and may change in the future. 

You'll find marketing information on the European Pension product in this blog.