Financial solutions for retirement: something more than mere products

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November 4th, 2013

Retirement is a highly significant phase in people's lives with far-reaching implications in many different spheres. The sphere of finance and wealth is one of these. Proper long-term planning is advisable to keep purchasing power at a suitable level once income from employment ceases. Such planning starts by setting a target,(1) involves assumptions or predictions related to certain variables and includes gauging the risks and tolerance of these to ultimately establish an agenda of actions to be taken. Throughout this process, it is very useful to know the range of financial products available as well as any other investment vehicles that could be used to achieve the goal. Some of these are specifically designed, by law and/or by financial intermediaries, as savings products for retirement and therefore offer particular advantages that should be taken into consideration.

Although they may have received less attention than corporate finances, academic studies on household finances contribute thoughts, figures and conclusions that are useful when planning for retirement.(2) First of all, based on life cycle theory, there is a need for a person or family to contemplate retirement at the same time as other landmarks such as decisions regarding the time and resources to be devoted to education and training, whether to buy or rent a home, descendants, inheritance, etc. Logically this merely accentuates the complexity of the problem. Moreover, other focuses emphasise the existence of additional elements: restrictions (a clear case when individuals own assets that cannot be sold directly, such as human capital), friction (for example, in getting a mortgage and therefore buying a home), distortions (such as those caused by taxes) and the environment of high uncertainty inherent in decisions involving such a long timescale. The existence of certain cognitive biases that move people's behaviour away what is rational is another important factor, identified in studies from the field of behavioural economics.(3) As a result of all the above, it comes as no surprise that, given the difficulty of this problem, family units may make «mistakes», sometimes far-reaching ones, when taking decisions about savings or investment with a view to retirement. One of the most significant mistakes is the low or zero investment in shares and other risky assets (but also prospects of a better return). Also anomalous is the low degree of diversification and bias towards local assets among household investments. But perhaps the most significant dysfunction is the phenomenon of procrastination:(4) in general, individuals tend to systematically postpone those decisions that entail some kind of sacrifice or concession in the present and result in a benefit that can only be enjoyed in the distant future. Within the context of retirement, this kind of behaviour can lead to savings that are clearly below what is necessary or optimum. Savings products that include a strategy to enforce discipline and a long-term view are highly recommended to assuage such a weakness.

Comparative statistics(5) point to Spanish households suffering from such problems. Investments in pension funds and insurance policies, which are products specifically designed for retirement, only account for 14% of their total financial assets, very far from the European average(6) which stands at 37%. Moreover, positions in mutual funds and listed shares, also associated with the long term, stand at 12% while the average in Europe is 17%. In contrast is the high relative weight of bank deposits, considered as safe and very liquid assets, which account for 50% compared with 34% in Europe.(7) But undoubtedly the differentiating feature for household wealth in Spain, considering not only financial assets but also property, is the preponderance of housing and real estate in general. The share of households that own their home(8) reaches 83%, appreciably higher than the 60% average for the euro area and a long way from Germany's 44% and France's 55%.

Certainly, bank deposits, on one side of the spectrum, and real estate, on the other, are viable instruments to channel savings towards retirement. They have failings in terms of profitability (particularly when we consider taxation and maintenance costs), risk diversification and liquidity (the former too much and the latter not enough). It is also doubtful whether they are the best option to assuage the problem of procrastination. It therefore seems advisable for Spanish families to focus more on financial products that have been specifically designed for this purpose. There are two basic types: pension plans and savings plans. Within the first category, of note are individual pension plans (IPPs), which are shares in funds managed by «collective investment scheme management companies». In this product, the person participating in the fund, by means of one-off or regular contributions (an excellent mechanism to combat procrastination), delegates to a specialist company the management of the resources according to the investment policy established in the fund's prospectus, which explains the investment universe and criteria for diversification and risk control.(9) The capital accumulated can only be cashed in on retirement,(10) either as a single payment, regular income or a combination of both. In tax terms, IPPs have the advantage of reducing the taxable base for income tax by an amount equivalent to the contributions made every year(11) and, once the plan pays out, this is taxed as income from work. Savings insurance policies can take a range of legal forms: income insurance, life insurance retirement plans (LIRPs), individual systematic savings plans (ISSPs, another anti-procrastination formula) and unit-linked schemes. Some of their features are very different to those of IPPs: the insurance company guarantees a minimum return at maturity(12) and, in most cases, the capital invested can be cashed in at any time (subject to certain penalties).(13) Other financial innovations that facilitate retirement planning are those that allow the home to be converted into income once someone has retired, in particular reverse mortgages and life annuities from the property. The list could go on in other areas, with retirement insurance policies, survival insurance benefits, etc.

In short, families have a wide range of products at their disposal that are of great use to overcome the complex challenge of planning savings for retirement. Properly combined, they help to broaden investment opportunities, diversify and limit risk, reduce costs, take advantage of fiscal benefits, improve the attributes of traditional assets and avoid the traps set by human behaviour itself in matters of finance.

Financial Markets Unit, "la Caixa" Research

(1) Quantify the desired purchasing power and discount the amount received via a public pension and other possible income.

(2) See Campbell, John, «Household Finance», presidential address to the American Finance Association, Journal of Finance 61, 2006.

(3) See Shlomo Benartzi and Richard H. Thaler, «Behavioral Economics and the Retirement Savings Crisis», Science Magazine, Vol. 339, 2013.

(4) «Retirement Savings and Decision Errors: Lessons from Behavioral Economics», Federal Reserve Bank of San Francisco Economic Letter, 2008.

(5) Data compiled by the Asociación de Instituciones de Inversión Colectiva y Fondos de Pensiones (Inverco), referring to 2011.

(6) The considerable differences in the structure of financial savings of Spanish households compared with the average for the euro area may be due to many different factors. Although the identification and analysis of these goes beyond the confines of this article, some of the key variables that may help to explain the particular features of the Spanish case are related to the level of risk aversion among households, the legal framework, as well as the specific fiscal structure of savings products and the population's level of financial education.

(7) 24% of the remaining assets in Spain are distributed as follows: 4% in bonds and 20% in other assets. For Europe, investments in bonds (6%) and in other assets (6%) account for the remaining 12%.

(8) «The Eurosystem Household Finance and Consumption Survey», European Central Bank, 2013. Data for Spain corresponding to 2008.

(9) The risk profile varies depending on the fund's investment policy. Normally, funds with great exposure to equity have a higher associated risk than those investing their assets in bonds and the money market.

(10) In the event of permanent inability to carry out any work, physical disability, severe dependence, death or legal unemployment, the participant (or beneficiaries) can cash in the pension plan.

(11) The limit is set at 10,000 euros per year and at 12,500 euros when the participant is aged over 50.

(12) Except for unit-linked, where the investor assumes the risk of the investments made (mainly in mutual funds).

(13) The main difference between LIRPs and ISSPs lies in the tax treatment applied. In the case of ISSPs, the premiums do not reduce the income tax base but any returns generated are exempt from tax provided the capital accumulated is not cashed in for 10 years, annual contributions do not exceed 8,000 euros and the cumulative amount of these does not exceed 240,000 euros. In the case of LIRPs, any contributions made reduce the income tax base and benefits are taxed as income from work, as with ISSPs. However, unlike ISSPs, LIRPs cannot be cashed in early except under those circumstances mentioned in the footnote on page 10.