German Pensions: The 6 Biggest Mistakes You Want to Avoid

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Dr. Christian Mulder

Jun 13, 2022
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The German pension system is complex and, unfortunately, this makes it easy to choose the wrong products and make unwise investments. These mistakes can eventually be disastrously costly, and especially painful when investing to secure your retirement. After all, exactly what we want and deserve after decades of hard work: is a financially secure golden age, or even better; an early retirement. Nobody wants to knowingly squander this important long term goal by choosing the wrong products, or investing in the wrong direction altogether.

To help you in achieving a secure retirement, we have compiled the six worst mistakes to avoid at all costs when it comes to pension investments. We also reference what you might do instead.

Mistake #1: Choosing a Pension Insurance With a (Partially) Guaranteed Return

It sounds great to have a guaranteed return, but typically these come at the expense of creating a very low return.

For fully guaranteed products this fact has become clear to nearly all. Guaranteed returns have fallen to such low levels (currently 0.25 %) that classic capital life insurance products offering such returns have become highly unpopular. In response, insurance companies have introduced partially guaranteed products that are not bound by the official minimum return guarantee.

Billed as chance rich and value safe options, these "new" products have proven to be rather popular, as they give a sense of certainty and appear different to the now tainted classic capital life insurances. By and large, though, it is old wine in new caskets: as such products similarly have dismally low returns.

Choosing a guarantee typically means the guaranteed part of the product will be invested in bonds with minimal or even negative returns. Be aware that you also have to pay high fees (usually 1-2 % annually) to the insurance company, so your net return could compoundly be negative, with these fees deducted from the (guaranteed) return. 

There are also complex guaranteed products like Index Select from Allianz that use financial derivative strategies that aim to secure higher returns. Historically these strategies show returns over the long-term, after cost, in the range of 0-2 %. These returns are trending down, as they have been used more and more, and the companies offering such products cannot promise these same results for the future. The guarantees only apply to the returns before cost. In this article, we spell out the risks of these products in detail.

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Mistake #2: Choosing a Product for the Tax Benefits & Ignoring the Costly Strings Attached

We can all agree that tax benefits sound great on paper. Who doesn't want to pay less tax? In particular, the direct company pension plan (direct Vorsorge / bAV), which is offered to most employees as an additional pension, suffers from this issue. 

Unfortunately, in the context of pensions these subsidies disguise some serious problems. In essence, this is because:

  1. The subsidy you get is de facto a loan from the tax office that has to be paid back.

  2. The benefits come with overcompensating security strings which limit the ability to invest your pension assets productively, and in the end, more than defeat their tax benefits.

  3. Let's understand the loan aspect. If I were to contribute 100 € per month through my bAV, plus 100 € extra as my company doesn't pay tax or social security on my pension contribution and adds that to mine, I could invest 200 € per month. If I were to do that for 40 years I could amass 48.000 € in tax savings, on top of my own 48.000 €.

But we need to consider the strings and that this 48. 000 € tax saving is not a subsidy, and has to be paid back at a later date. If, as a result of the strings attached, my net return on the pension investment is just 1 %, then this tax benefit doubles my return. Instead of making 1 % on 1.200 € (or 12 €), I make 1 % on 2.400 € or 24 €. 

Therefore, I could effectively benefit from a 2 % return on this amount. 

When bond interest rates were high, this was no problem. Your 5 % gross return after 1,5 % cost would yield 3,5 %. Double that to 7 % and you face very attractive returns. Alas, if your net return after cost is 0,5 %, then your return is just 1 %. 

The reality is (see Mistake#1)  that your long-term expected return after cost is in the range of 0 to 2 %, although still not really guaranteed and trending down. If you double that amount due to the tax benefits, you would still earn far less than having a sensible ETF-based stock portfolio for example, that could earn in the 6 to 7 % range. 

In reality, the calculations are even more complex than this. Another important cost to consider is that the bAV reduces your official pension, as those "subsidies" include payments you would otherwise make toward this official pension, i.e., your GRV. This official pension can be expected to yield you a much higher return than the bAV.

Mistake #3: Choosing an Annuity/Fixed Monthly Pension

Again, it sounds good to secure a guaranteed monthly pension, also called annuity, from the savings you have accumulated, once you begin retirement and then not have to worry about anything anymore

Unfortunately, the implicit cost of these annuities has become immense. If you have accrued 100.000 € in savings at age 67, you can expect to only get back 65.000 € during your retirement, considering normal life expectancy. 

When bond rates were high such guaranteed pensions made sense, as insurance companies could invest your savings in bonds with a high fixed return. Now, however, interest rates are very low. 

As people live longer, the cost of not investing properly is becoming huge. Imagine your capital just being dead for 20 years, not yielding any return, and only accruing cost. That is precisely what happens with these products.

Moreover, for the possibility that the insured outlive the average life expectancy, insurance companies retain high buffers, meaning you won’t see a large sum of your pension savings until your fellow insurees start to die and the insurance company feels it is a safe time to pay out the monies reserved for them.

Your alternatives:

  • See if you can contribute extra to the GRV when you are over 50, as the public pension pays till the end of your life, and has an expected net positive return of at least the inflation rate, so it e.g., beats the bAV hands down in the current situation.

  • Invest in a home, and thereby earn a rental income that grows over time, while the investment property also increases in value. 

  • A properly spread basket of stocks will yield more than an annuity, even in the worst case scenario, if held long enough (at least 10 years). A better strategy than buying an annuity immediately upon retirement is to invest in ETFs until about the age of 73-77 and then buy an annuity if your buffers are limited, as by then you can not wait for your stock to rebound.

  • Work an extra year and use that buffer as a cushion for your ETF portfolio.

It also means that when you have the option, as you have with the bAV or partially with Riester, you are virtually always better of with choosing the lump-sum payment as it avoids the implicit cost of the guaranteed annuity, is flexible and always allows you to buy a more cost-effective annuity later in life, i.e., for a shorter period. Keep in mind that the lump sum option of the bAV lands you in a higher tax bracket, so the impact of this must be weighed as well.

Mistake #4: Choosing a Pension Product With High Fees

We see many people choosing pension products based on the big names behind these products, whilst simultaneously disregarding their costs. This is very unwise. Especially when you invest in ETFs, as you take the risk, and not them. You will bear the costs, and only support the advertising that keeps up their name, not your pension. 

The effective costs of German pension solutions can be shockingly high. For example, the median cost of a Riester product is 1,66 % per year and of Rurup 3,02 %. We have even viewed examples with costs exceeding 4 %. 

One might mistakenly think that 2 % costs are modest compared to the returns and considerable tax benefits. But let's be clear about this: this is wrong! Let's look at the effect of a 1,5 % cost, which is on the low side in the insurance industry. It still creates quite a drag on your portfolio. Assuming a return of 6 %, your contribution of 100 € per month grows over 40 years from 48.000 € to 134.000 €. If your cost is 3 %, you end up with just 93.000 €. On the other hand, if you reduce the cost to 1 % you will have 152.000 €. That's 70% more than when considering a cost of 3 %!

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If you choose to invest in ETFs/stocks for the long-term we recommend to use a low-cost Pension Plan that functions as a tax shield for your ETFs. Read more in our article The Smartest Way to Invest in ETFs in Germany.

Mistake #5: Not Investing Enough in Stocks

The most important decision when investing for your pension is the so-called ‘strategic asset allocation’. How much to place in stocks, bonds, real estate or other investments (commodities, etc.). In choosing their allocation most people opt for what they think is caution. And as stocks are volatile, most people consider them risky. This view we would like to strongly discourage.

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Fundamentally, over the long term, stocks are safer as they grow in line with the economy - at least if you invest in a broad stock index or basket. In the short term, of course, stocks can be volatile, as markets can be overly concerned or overconfident as they react to events. This was seen recently with the large fluctuations at the start of the Corona pandemic and also more recently with Russia's invasion of Ukraine when stock prices took double-digit losses.

Therefore, the greatest risk when considering stocks is timing. Stocks need to be held for at least 10 years for them to become virtually sure to have a positive return.

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In this regard bonds are actually the more risky option. If you invest in a 30 year bond at 1% interest, you gain 35% over 30 years, but the purchasing power is eroded by 35% – assuming 2% inflation, the target of the ECB. With current high inflation rates, you would lose even more.

Find out more about how pensions work in Germany.

Mistake #6: Actively Managing Your Stock Portfolio

Finally, one more big mistake to avoid, that applies to (pension) investors all around the world and is presumably the largest mistake made among all private investors.

It is quite natural that you want to control your investments as much as possible and thereby hope that these will be safer. We all do the same; with cars, houses, and all material things that we hold dear. We maintain and check them in order to secure them.

But when it comes to investments, this is not the way to go. Active management rarely leads to outperformance. Rather, it leads to additional costs. For individuals it is especially hard: they usually lack the disciplined frameworks of professionals and above all, access to information. Professionals use benchmarks to compare their returns to and measure their (out)performance, in both risk and return. E.g., professionals compare the ratio of outperformance to the increased risk, approximated by the Sharpe ratio, to make sure to achieve the best risk-adjusted return on a financial portfolio.

Individual investors, on the other hand, rarely track their performance systematically. Although they regularly look at their portfolio and are happy or frustrated about the current status, they usually do not have the discipline to evaluate these developments against benchmarks. So a typical individual investor shares news about their better performances and then feels compelled to sell if only to tell of how much they made, and on the other hand is generally quiet about poor performances and inclined to hold on to them until they eventually turn a profit. As a result, they sell their good stocks too quickly and hold on to bad performers for too long. This is one of the main reasons why individuals tend to perform significantly worse than the indices. 

Indeed, for everyone outperforming the market there has to be someone underperforming. The professionals with access to all the information are more likely to make any profits that exceed the index whereas most individuals lose compared to the indices. 

What then should you do? Nowadays this is super easy: you can choose very broad indices that are automatically rebalanced (weak performers drop out, strong ones enter) and dividends are automatically reinvested, avoiding the need to pay dividend tax or the upkeep of reinvestment. And this is at very small fees. For 8-20 basis points, which means 0.08-0.2%, you can invest in the best indices. 

Following your investment, you should follow a "buy and hold" strategy, keeping your hands off and avoiding active management. It only makes sense to fundamentally rebalance your portfolio when you are approaching retirement, if you need to reduce risk or when interest rates are significantly positive again. 

Whether you rebalance or actively manage your ETF portfolio, there are profound tax implications. This is why we recommend an ETF Private Pension Plan product, as this will help protect your gains from taxation and ultimately generate higher net returns.

Check here if a Private Pension Plan is the better fit for your investment strategy.

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Dr. Christian Mulder

Dr. Christian is a former Senior Economist and Manager at the IMF and World Bank. He is a Hypofriend Co-founder.

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