A proposal for EU private pension reform.
Based on 4 years of building a pensiontech called Horizon65.
If you haven’t please read the proceeding post first that iterates the problems below
Problems facing retail investors in regards to private pensions.
Overconfidence in their investment abilities
Very low confidence to start investing with their money
Information overload on social media lowers confidence further
Complicated contracts
Loss-aversion especially when it comes to liquidity
Unwilling to pay for advice
They get stuck in analysis paralysis especially when they have to give up flexibility
They don’t understand taxes
They are both active and passive investors
They do not save consistently
They want to buy a house
They often want to withdraw for big expenses (car, travel)
Workplace pensions require employer signatures
Workplace pensions have restricted mandates due to mandated guarantees
Entrepreneurs rarely care about company pensions
They want to retire early
Moving around in Europe requires pausing existing contracts and opening new ones.
They want choice over where the custodian of their money is
They want to protect their partner when they pass away
They want their children (or dedicated beneficiary) to inherit their money
They do not understand the impact of inflation
The technical solution obviously needs to have some elements such as
Interface to the pension needs to be developed by the private sector
Should be fully digital
Should not create monopolies (e.g. Datev situations) so moving your “account/interface” should be easy
Should be multilingual
Should be secure
Should be private
But I mostly want to talk about the complete solution including legal, prudential, tax and prudential concerns.
Pensions are always personal
There are occupational pensions in many countries and there are the 3 pillars (state, occupational and private).
But pensions are always tied to the individual.
There are proposals for auto-enrollment of all employees into company pensions but this is a mistake. Auto-enrollment should definitely happen, and it could be introduced through companies but they should not be tied to the company in any way.
One only has to look at the UK, where a dedicated startup exists (Pensionbee) to unify company pension pots into one or one can look at Germany where company pensions are introduced by the company but where the employer stays liable for the outcome.
In Germany there’s also a mess with changing companies, where many contracts are transferred to a new contract or just discontinued and a new one is started.
Pensions should always be personal and pension investment accounts should be tied to the person, not the company.
This requires that they are decoupled from labour law.
This doesn’t necessarily change anything on the amounts transferred into the contract and the tax benefits of such an investment.
It’s perfectly possible to have many different pension pots, following different taxation schemes in one pension investment account.
With multiple pots in one account, there is freedom to invest in everything
The government restricts tax benefits to safe investments but this actually triggers a huge amount of loss aversion among retail investors.
They STRONGLY prefer to be free to invest in what they want.
If there are multiple “pots” of money inside one account, then both can get what they want.
This also solves the issue for expats that they have multiple pension investments in multiple countries. One could follow Portugese tax benefits while the other could follow German tax law.
It also solves a critical issue for the industry, as it enables easy sign-up for a trade account (signup bonus) and then it can also be used as a pension pot for occupational pensions, tax-advantaged private pensions, …
All money pots should be liquid
Another strong point of loss aversion is the lack of flexibility to withdraw.
Governments impose these lock-in for good reasons as they are providing significant tax advantages to retail investors. In Germany the Rurup for example can lower your taxable income by €28,091. The downside is that once you wire money into such a contract you can only take it out at 62.
I strongly believe this is the wrong approach, the government should immediately match the contribution with the tax advantage AND the contracts should remain liquid.
However, should the investor want to take the money out then the tax advantage on the withdrawn money should be cancelled and capital gains tax (if applicable) should be applied on the gains.
This allows people to access the capital but it also creates a huge amount of loss aversion.
In the case of the Rurup, taking out those 28,091 euro again after one year might actually cost you €28,091 + €11,236 (40% of income tax) + €491.50 (Capital gain tax on 5% annualized interest) = €39,818
Getting 28k but losing ~12k of your balance is a very strong incentive to remain invested.
This is easily manageable with technology.
Every EU citizen should be auto-enrolled from their very first job
We are mandated to create social security numbers when we start working, this should be included in this process to make sure that every working EU citizen has a pension account.
This can be integrated with the EU pension dashboard by default.
But do note that it should be possible to switch your preferred interface away from the “basic” EU portal to a more user-friendly option.
The government should mandate companies pay 5% of the wage into the company pension pot
Importantly, THIS IS NOT A TAX as the person can withdraw the money.
However, the person will see the benefit of a company pension and has to go through loss aversion to access this.
This is intentionally designed as an opt-out system because retail investors almost always start saving too late due to indecision.
The implementation can be that the government collects the money and then deposits it into the account to avoid extra company overhead. However, the incentive for the government to raise the income tax would be enormous so it’s better the company pays it in directly without government involvement.
The % should be adjustable by the retail investor but can only be lowered for a period of 6 months. This provides a relatively frequent reminder to people that they should really save for their retirement and twice a year is not particularly burdensome.
The government should automatically invest the cash into the default investment option after one month
Retail investors are stuck in analysis paralysis and this will force them to decide where to invest OR just go with the default option selected by the private company.
This would create a lot of incentives for asset managers and banks to create really user-friendly interfaces.
In any case, the default option should fit the retail investors’ risk criteria AND be on a government curated list of allowed default options.
The “contract” should be centrally managed by an EU regulator.
This guarantees that all the legal obligations are the same across the EU and eliminates the confusion caused by retail investors trying to figure out what they are actually signing up for.
This also allows easy portability between platforms.
The pension pots should have beneficiaries for both survivors and inheritance.
The treatment of tax-benefited money varies from jurisdiction to jurisdiction and allowing them to configure their preferences for every money pot will also educate them about the treatment of their money in case of death.
The pension pots can have investment strategies and defined-benefits
To maintain compatibility with existing pension plans, some pension pots will have mandated investment strategies with guarantees.
They should also be clear where the custodian is and which company is managing the pot.
In an ideal case, the pension pot investment strategy can be adjusted and the correction in defined-benefit can be clearly agreed upon.
In effect, this is a centralization of the management of existing pension pots across the EU.
There should be pots that are direct investments and act as trading accounts
When there are no limitations imposed by the government it should act as a trading account similar to Scalable capital/Trade republic.
This means both active and passive investors are catered for, as well as those who want to invest in very risky investments without tax benefits.
This avoids loss aversion.
It also creates a situation where a very risk-averse investor is following the recommendation of a high-risk investor and is then able to adapt the investment strategy to their low-risk preferences.
The pension pots can price liquidity at different notice periods
It’s not always feasible for pension funds to divest from illiquid investments in order to payout withdrawals. In effect, a pot should be able to configure notice periods for liquidity but those should not exceed one year.
There could be alternative methods for liquidity such as providing a credit facility for pension funds to make funds liquid but charge interest which can be charged back to the retail investor.
There is an inherent conflict between long-term investing and liquidity.
The ECB should be involved as some mechanisms are needed.
In theory, guaranteeing liquidity could lead to a "bank run" on a pension fund. Therefore, a mechanism must exist to discourage withdrawals, or the ECB may need to bridge the liquidity gap, as it does for banks.
The ECB is already needed in the design for a pan-european pension framework in order to enable defined-benefit pension funds to invest more in equities.
Because many countries constructed occupational pensions as deferred compensation, there are guarantees tied to existing pension schemes. These guarantees are often so rigid and must be upheld daily due to Solvency II.
They cause many firms to adopt overly conservative investment strategies to avoid breaching the guarantee requirement and that means minimizing their investment in volatile investments such as equities.
This restrictions are not in place in US defined-benefit pension funds, who do actively invest in equities.
There should be an easy calculator to see the accrued pension adjusted for inflation when they retire
This should include their state pension actually but it has to display the amount after-taxes. This is important because many retail investors do not intuitively understand the difference between gross income and net income.
The accounts can be delegated to licensed investment advisors
Let’s face it, there are people who just don’t want to deal with finance and gladly pay others for it.
Centralizing this also allows oversight of investment advisors actual activity which will greatly help purging bad apples.
I would leave the business model and selection/recommendation of investment advisors to the private platforms
There is no really good solution to mitigate conflicts of interests with advisors and it’s unlikely a government mandate will be able to establish the needed trust.
The pots can be collateralize for mortgages or loans
People want to buy a house but it shouldn’t really be necessary that they sell their stocks to do so. Just putting the contracts up as collateral and making it easy to borrow against the liquid part of their pots should be enough.
Those collateral claims (liens) should be clearly recorded to avoid people getting multiple mortgages in parallel with the same collateral.
Conclusion
This solution works by taking advantage of loss-aversion to get people to start investing.
It’s built on the insight that loss aversion does not just apply to financial loss, it also applies to loss of freedom, loss of liquidity, loss of investment choice and loss of future life plans such as buying a house or retiring early.
Any successful scheme has to be a “no-brainer”, in the sense that the retail investor does not lose anything.
Once the funds are in the account though, the funds are automatically pushed into an safe investment which breaks the retail investors’ inertia to get started.
In my experience, once investors get started they can observe the investment and learn while doing.
The revocation of tax benefits on withdrawal is another loss-aversion mechanism to keep the funds invested and to have the retail investor face the opportunity cost of not investing it. That same opportunity cost is extra visualized in the long-term by the altered pension dashboard.
By design it is a flexible and lifelong EU pension account that clearly manages expectations of what they can expect of their investments and periodically reminds them of the importance of saving for their pension.
The multiple pension pots allow national schemes to be incorporated as well as national laws and tax regimes to be applied where necessary.