In Germany, most employees are offered a direct pension plan (Direkt Vorsorge) known as a company pension plan (Betriebliche Altersvorsorge or bAV) by their employer. It sounds attractive: enrolling in a savings plan subsidised by both the government and your employer, and it may well feel like the responsible thing to do.
In reality, it is one of the biggest financial mistakes to be made.
The key points
Upfront Costs of Direct Company Pension Plans Make Them Unattractive for Job Changers
Most direct company pension products charge upfront fees. The company contracts with an insurance company which in turn bills you. Insurance companies can charge up to 2,5 % of the total committed sum till retirement age in the first 5-8 years and usually do so.
For example: if you invest 100 € per month or 1200 € per year and you are 27, these fees calculate to: retirement age of 67 - current age of 27 => 40 x 1200 € x fee of 2,5 % = 1200 €.
Meaning within the first 5-8 years you lose one year of contributions in up front costs alone!
In addition, the insurance company will charge an annual fixed cost and a fee of around 1 % on the asset value.
Why are these upfront fees so bad for your investment? After you change jobs all subsidies fall away.¹ So you may pay the upfront cost, and be left with a product accruing high annual fees that is worth less than the money you have invested, and on top of this, you no longer receive the subsidies you were counting on. This can affect many people, particularly with the shifts in employee priorities, we are seeing post the Corona pandemic.²
Many people may then say: “So what? I can just take the money out, and collect the subsidy and company support I already received.” Not so quick.
Many people find themselves with savings that they cannot access, i.e., “dead money”, as the contract does not allow cancellation. Only if the employer collaborates and the amount is modest (see table below).
Even if you can cancel the contract and get your assets paid out, you have to immediately pay taxes and social security subsidies. Effectively, you will have to pay back the 15 % standard top-up of your employer, plus all the other social security fees and taxes they otherwise would have withheld. Your total bill is likely to be more than what you got as so-called “subsidies”, as the taxes on a one-off amount will place you in a higher tax bracket.
Especially if you have not paid the full up-front cost yet, it generally pays to immediately cancel your contract and get your money out. The longer it runs the more you pay and the higher the tax bracket is when you get the money out. Also if you wait too long you may have to keep your money in forever, as dead money, as you exceed the limit.
In other words: only if your employer is very generous (and let's say were to triple your investment) should you even consider a bAV.
¹ Changing jobs almost always means that your current bAV switches to a Private Pension Plan (PPP) without subsidies, so you are stuck with a costly PPP. Only in rare cases does your new employer have the same solution as your previous company, allowing you to continue your existing plan.
²Gallup Engagement Index reports that 23 percent of German employees are looking to change jobs in the next year, and 42 percent are looking to change within 3 years. The number of people planning to change jobs is especially high for younger employees (under 35), but substantial even for those above this bracket.
What Makes the Direct Company Pension Plan So Unattractive in Any Case
Fundamentally, the returns on savings invested in a bAV are poor. The reason being that legally, a minimum of the paid-in assets have to be guaranteed. And it is very costly to provide a guarantee that your investment will not decline in value (see bAV comparison example using Allianz Index Select below).
It used to be that insurance companies would invest in bonds to guarantee certain returns. The return on bonds dropped to the point of no longer being able to offset insurance company fees (about 1,5-2,5 %), hence this no longer works. Insurance companies have therefore come up with complex strategies to offer somewhat higher returns but if properly evaluated it is clear these do not make sense in the long run. The figure below tells it all too well. The value of the product before cost is stable, but after cost, it can fall (shown in red). Investing in the index itself, through an ETF, yields a much higher return (shown in blue).
You may then think: “But the tax subsidy is so high.” Many people think it doubles their money, i.e., in Figure 1. the red line doubles. ALAS, that is not correct. Sure in first instance it almost doubles your money. But then in retirement you have to pay that tax subsidy back when the assets are paid out. You do have to be aware that the end tax on your gain is rather high as you have to pay social security contributions your employer would have paid as well as your own social security payments on top of the income taxes. In other words, on a net basis the red line in Figure 1. indicates broadly what you might end up with.
Another Hidden Cost Surprise Within the bAV
Another cost that most people are not aware of, is the huge implicit charge in the pay-out phase of your bAV. If you choose to have your built up savings paid in the form of an annual guaranteed pension, e.g., to help pay the rent, then the pay-out is very low: for each 10.000 € saved you only receive around 6.500 € (considering you reach the average current life expectancy of about 85).
This is due to the fact that the assets are not invested during the retirement phase--with the same problem as noted above for the pay-in phase, that they can only be invested in guaranteed products, now applies to 100 % of the assets. Moreover, insurance companies retain large buffers in case the insured live longer than the average current life expectancy. This could potentially lead to some surprise extra payments for those who live long, but this is a very poor basis upon which to plan your retirement financially.
If you choose to have your bAV paid out as a lump sum you avoid this tax, but you will be faced with an extra high tax rate as the sizable payment will put you in a higher tax bracket.
Direktvorsorge vs First Home
Buying a home is a much better idea for your long-term financial safety!
Firstly, the return on a home is much higher during the pension build-up phase than the bAV product, which can not be invested well. A house typically returns 3-4 % appreciation, minus maintenance, plus rental yields of around 3 %. Secondly, the tax treatment of a home is much better, as the return on a home is not taxed at all if you live in it yourself. Furthermore, if you stay a minimum of 2-3 years--there is no capital gains tax in the case of selling this investment (after 3 years).
Thirdly, unlike with a bAV, throughout retirement, your money continues as an investment, and your return is that you don't pay ever increasing rents.
In addition, consider the following:
If you purchase a house and then contribute more savings you further reduce the interest rate of your entire loan. If you can reduce the loan from 100 % to 95 % of the house price, the return on that money is typically about 5-6 %, each year for the life of the loan, net of tax. This is much better than the return on a bAV. And it certainly is better than dead money!
As the value of your house will grow over the long run, it creates a great store of wealth for emergencies, to make the house old-age proof, or to bequeath.
Finally, your home is secure. Rent increases can’t force you to leave. You can raise a family there, or just grow old. You paint the interior walls however you like!
Therefore it makes a lot of sense to save for your first home instead of going for a direct company pension plan!
The Best Strategy for You
Really, the big picture is not difficult.
It begins with saving for your first home. Your first home provides the best return and also offers you the best old-age insurance. Importantly you can avoid the risk of dead money that exists with a bAV.
If you already have a home, or a wonderfully low rent and don't like the idea of an investment home, then the second-best solution is to invest in ETFs. We suggest doing that through a tax wrapper, if it is potentially for your retirement. The low fees are offset by a smaller tax bill.
Unless you have a very generous employer that more or less triples your direct pension plan contribution, with a contract that allows you to cancel when you want to buy your first home, just don't go for it. Save in a bank account. You can also save in well-spread ETFs. Just keep in mind that if you do so and the ETFs perform poorly you may have to wait some extra months to buy a home.
If you already have a direct company pension plan but only a few years, then you have not paid all your upfront costs yet. You are then typically better off canceling your contract if you can, or stop contributing. You will have to check if the insurance company levies an extra penalty on withdrawal, and of course if you are allowed to cancel and withdraw the money.