To supplement your pension, a private pension plan (PPP) is often the best option as it has tax benefits, can be low in costs and has the best potential for a great return when invested in ETFs. There are, however, pitfalls that you need to avoid to get good returns on your contributions. We will show you how.
The key points
Private Pension Plans: A general overview
Private pension plans (PPPs) are very flexible pension products and there are plenty of products on the market that insurance companies are offering. The basic function is easy: You pay in a part of your income every month or every year so that when you retire you get a pension in addition to the statutory pension. Your contributions are then invested until you seek it to be paid out. And that’s where it comes to the crucial differences of the various offered insurances: the way that they invest your contributions. More on that here: Investment options for PPP
Private pension insurance also allow you to choose how you would like your pension to be paid out during retirement: notably as a lump sum or as an annuity. Most of the time you don’t have to decide this when closing the contract but you can decide this at a later stage.
Normally upon your death, the built-up capital including return is paid out. The sum paid to the beneficiaries in case of your death is tax-free. The annuity option is not permanently inheritable, but in many cases there is an annuity guarantee period ("Rentengarantiezeit") of usually 10 years. If you take out the annuity and die shortly afterward, your pension will be paid out to your heir until the end of the guarantee period.
With many private pension insurances, you have the option to include a disability insurance, a survivor's pension or additional accident insurance.
You can also elect to insure against conditions in which it is hard to pay your contributions, for example, if you become unemployed or destitute. However, experience shows that it is usually cheaper to take out this additional insurance cover separately. In addition, you will still have flexibility if you have liquidity problems. After all, if you reduce your pension payment for a short time, this has no effect on the supplementary insurance cover.
Optimal choices to structure your private pension plan
We would recommend against choosing the annuity option in the vast majority of cases. The reason is that these annuities are now invested in low return bonds and attract a lot of costs. As we are now very likely to live to 80 and more, you should keep investing properly for a much longer time, to at least 15 years before your expected death.
Choosing the lump-sum option avoids the implicit cost of the annuity, is flexible and always allows you later in life to buy an annuity. If you do so you may instead want to consider multiple private pension insurances, each paid out at a later date. This is beneficial because you'll only pay taxes once each. For example, if you paid it all out at age 67, reinvested half of it, and then cashed it out at age 80, you would not only pay reinvestment fees again but also forgo a return on the part you have already paid to the tax office.
Three different types of PPP, but only one real option
When you are looking to secure your standard of living in old age with a private pension insurance, you should pay close attention to which form of private pension plan you choose.
First, there is the ‘classic model’ of private pension insurance. As with Riester and Rürup pensions, you get a 100% guarantee on your paid-in contributions here. But it is also tied to the guaranteed interest rate of currently only 0,25%. The guarantee implies that the classic PPP is very conservatively invested in bonds with low or negative yields. As costs are deducted from the guaranteed return, your net return is most likely actually quite negative. For example, if your investment return is equal to the guaranteed 0.25% and your cost is 2% annually (this is a pretty common cost level) then the guaranteed product loses you 1,75% per year!
There is now an approach to solving the problem of classic private pension insurance via partial guarantees. With this ‘new classic model’, you can choose the level of the guarantee and then when there is outperformance this money is better invested. In essence, this is the old wine in new bottles. It is no better than the Classical model. It is a way for insurance companies to avoid having to advertise the low minimum guaranteed return. As long as bond rates are low or negative, the guaranteed money is de facto returning basically 0, while they still attract high fees, and so in the end you get a significantly negative return. You are better off with putting any "guaranteed" part of your investment in a bank account or repaying your mortgage.
Therefore, we advise you all the more to choose a third form of private pension insurance: an ETF-based PPP. With this form of pension insurance, you no longer have any guarantees, but you do have the opportunity to benefit from the developments of a broad stock market. The great thing about ETFs is that they are safer than government bonds in the long term, by protecting against inflation and generating higher returns, as stocks keep up with the economy (including inflation and real growth).
Fees for private pension plans
We have already stated that we absolutely do not recommend the ‘classic’ model of private pension insurance or the ‘new classic’ model - also because of the sometimes very high fees. That's why we only want to discuss the fees of the ETF-based PPP model we recommend here.
To assess the overall costs, each contract comes with an effective cost number ('Effektivkosten') which indicates how much the aforementioned fees reduce the annual return. For example, if the funds in your contract are targeted to achieve a gross return of 6% and your contract has 2% effective costs, you will have a net return of 4%. It can be used to compare different contracts since it represents the impact of all fees on return. It is common to find the effective costs in the range of 1,4-2%, but we have seen amounts as high as 3,5% and as low as 1%.
And while the difference between 1% and 1,4% may not sound all that much, it can certainly make a significant difference over the long run!
The effective costs in turn are composed of several elements, including upfront fees, fees on the amount paid in, annual fees on the capital build-up and monthly fixed charges. In particular, the upfront fees can be quite damaging. Many companies charge up to 2.5% of the total insurance sum that you e.g. commit to contribute over 30 years upfront. It means that it takes a lot longer for your capital to build up and start earning returns and that if you decide to stop contributing, you have costs that are much higher than the predicted effective costs. Also if performance disappoints you actually pay relatively more than what you were told were the effective costs, as they are based on the return assumptions. We therefore strongly advise finding providers which charge mainly or only based on the actual assets.
Tip: While most insurance companies consider the highest, others consider the lowest cost fund, which can make a massive difference, thus when comparing effective cost you have to be very careful. In the contract, the providers also specify the maximum cost of canceling the pension, or changing the contract called 'Kündigung wegen Vertragswechsel' and 'Kündigung mit Auszahlung'.
Tip: We have seen really high penalties for canceling contracts, like forfeiting all returns. Do review these clauses closely, and consider stopping additional contributions instead of canceling. For the phase of retirement, there is also a one-off administrative fee of usually 1,75% for the pay-out.
As you can see, fees can significantly cut your returns. Be aware that typically insurance brokers get paid more for expensive products. So it's worth taking a close look when choosing your PRV. At Hypofriend we have created our own effective cost calculator so we can check the cost of different products and we have preselected the cheapest providers.
Tax benefits and penalties with a private pension plan
In the pay-in phase, there are no tax benefits with your private pension insurance, so you can’t deduct your contributions from your tax bill. There are some potential tax benefits for PPP products, but only in the pay-out phase. The tax then depends on the payment option.
Annuities are subject to income tax but in a rather complex way
If your pension is paid out as an annuity, then only a portion of your monthly pension is taxable. Keep in mind though that the tax is levied not just on your gains but also on your contributions.
The taxable portion of the pension depends on when your annuity (“Leibrente”) commences. For each age, there is a different corresponding percentage of pension that can be taxed. Generally, the older you are, the lower the tax rate.
Only the so-called "Ertragsanteil" is taxable. For example, if you retire at 62, only 21% of your pension is taxable. Therefore if you receive a monthly pension of €1000 and your personal income tax rate is 30%, you have to pay 30% x 21% x €1000 = €63 per month of income tax or about 6% on your total gross pension. The share of pension income that is taxed ("Ertragsanteil") remains constant for the duration of the whole pay-out phase.
See the second table on this page for the rates for all ages from 50 to 100 and the corresponding amount taxed.
Note: You pay the calculated 6% tax rate in the above example over the entire sum and not just on what your investment has gained! So if your return on your private pension insurance is poor the tax rate is actually rather high and vice versa. So from a tax perspective, investing in low return products (such as those with guaranteed returns) and then getting an annuity is a bad idea. For example:
With an investment of €200, capital gains of €800 and a tax of 63 your gains are taxed at a rate of 63/800 = 8%
On the other hand an investment of €900, capital gains of only €100 and a tax of €63 means your gains are taxed at a rate of 63/100 = 63%
As the ‘Ertragsanteil’ only depends on the age at which you start to pay out, it is beneficial, from a tax perspective, to start the PPP early if you choose an annuity: it means you have a long period to build up a high return. It also implies that you should only choose the lump sum version if the run time is short.
The lump sum payment is subject to a reduced capital gains tax: the beauty of the tax wrapper
The lump sum version of the PPP is only subject to a capital gains tax, i.e. a tax on the return of your investment after any cost. The tax is levied when the investment is sold. The tax rate in Germany is a flat 25% plus a solidarity surcharge of 5,5% on the tax paid for a total rate of 26,375%. The first 801 Euros are tax-free.
If you hold the PPP for over 12 years and take the whole sum out in one go after the age of 62, you only have to pay only half the capital gains tax rate and hence save about 13,19%.
If you invest directly in ETFs yourself, you would have to pay 26,375% capital gains tax on the profit of every sale, which tax is withheld by your broker.
Even if you switch the ETFs to rebalance your portfolio, you pay taxes. That's why you will get more return in the long run with a low-cost ETF PPP than if you buy ETFs yourself:
To optimize your taxes, you will typically want to conclude several PPPs and have them pay out at different times. In the flexible PPP that Hypofriend would recommend, you can then add over time amounts to the different PPPs without incurring additional costs.
Immediate pension with a one-time payment
You can also use the PPP to obtain an immediate pension. With this option, you pay in a lump sum and receive then in return an immediate annuity - for the rest of your life. You also have the option to choose if you would like a fixed higher pension in one phase of your pension and lower in another (called dynamic annuity).
This option can be considered if you are close to retirement and have a larger amount of money at your fingertips, for example from selling a property, an inheritance or a life insurance payout.
With current interest rates and the way insurance companies calculate life expectancies the annuity is relatively unattractive. For a payment of €100.000, for example, you can expect a gross monthly pension of around €330 from the age of 67 on. So you would have to get pretty old and draw the pension for more than 22 years to get your money back.
In principle, you are better off buying your own home or contributing as much as possible to the public pension (the GRV). Also working an additional year to create more of a buffer and then investing this money gainfully in ETFs would result in a much higher buffer later in life. But if you don't have those options and want to make sure you have a minimum guaranteed income throughout the rest of your life, then this is the option to choose.
Note: Life insurance vs private pension plan
Capital life insurances (CLI for short or ‘Kapitalebensversicherung’ in German) have in practice the same options as private pension insurances which is why we just refer to the latter. For example, both products can be chosen with lump-sum payouts and life insurance options. It is about deciding what options to use and not about the name.