Would private pensions provide higher welfare to low income households?



People assume that the social welfare is essential to make sure that all the population has access to some basic life standards. One of the best examples of this belief is the public retirement pension. The idea that some segments of the population would never be able to have minimum life standards without the help of a social welfare is quite strong in most of the European countries. The idea looks pretty obvious after a simple analysis: it is impossible for a low income population to save enough money to live without working for 15 or 20 years. However, this conclusion may be wrong after a more rigorous analysis.

We must look for a kind of investment that gives a return high enough to be able to save the money needed to live for 15 or 20 years. We may find that investment in the stock markets.

Firstly, let’s take a view to the stock market’s trend in the last 30 years to check the return we may get even if we do not have any financial or investment knowledge. If we take the British stock market data (FTSE 100) we realize that the arithmetic mean is 7,21% annually for the entire period, and the geometric mean (the effective annually return) of this index is 6.04% in the last 29 years (1985-2013). It is quite a high return taking in consideration normal profit we may get by investing in deposits or bonds. Let’s check some other examples: The IBEX 35 (Spanish stock market) has also a very high return if we measure its performance in the last 20 years (1994-2013), during that period the Spanish index had a arithmetic mean of 8.08% per year, and a annual return of 5,18%. These results become even higher if we take a longer historical period. For the last 2 examples we may check the performance of S&P 500 and the DAX 30 (USA and German stock markets) since 1980, in this case, the USA and German exchange had 8.71% and 9.08% average annual return, respectively. We would find similar results if we analyzed other indexes for a 30 year period.

The evolution of the stock markets since 1980

The evolution of the stock markets since 1980

The conclusion we have after considering the evolution of stock markets in the long term (periods between 20 and 34 years in our examples) is that they give a very high return and the chance of losing money is close to zero. On the contrary, investing in shares in short term like 2-3 years is much more risky, because then we are exposed to business cycles and stock market’s panic, but the stock markets have a high accuracy in the long run that makes disappear those risks.

However, these returns do not take into consideration the effect of the inflation, so the real returns of investing in the stock markets should be lower. If we check the results of the S&P500, since January of 1871 (and we discount inflation), we may see that the return of this index for a period of 143 years is 6,82%

Secondly, we already know how high the share’s return is, but how much money would a person save if he or she has a low income? Most of the advocates of the social welfare state argue anyway that earnings a family unit needs to save are too high for a low income household. Let’s make the calculation:

According with what we already said regarding stock returns, we could agree that 6,8% would be an appropiate yield to use for calculating a private pension. However, not to be accused of an excessive optimism, we will use the return of 5,5% (inflation discounted) according with the well known book “Triumph of the Optimist- 101 years of Global Investment Returns” and the modern generally accepted return of capital in the long run. Besides, for calculating the pension of a family, we will use as the saving rate 50% of what a low income household (18,283€ per year) pays for social contributions in Spain: 50% of 5,102€ (worker social contributions + company social contributions, as the second one is also laboral cost, and otherwise it would mean a higher salary for the worker) = 2,551€. In this example, the result of saving and investing 212€ per month (50% of social contributions payed by a low income household in Spain) in the IBEX 35, FTSE 100, S&P 500 and DAX 30 (for example) since a person is 25 years old till 65 (40 years working and saving) at a return of 5.5% (by using the compound interest mathematical expression) is 400,871.31€, which means 1,670.07€ monthly during 20 years (from 65 to 85 years old). That is quite higher than any European country public pension.

The calculation doesn’t take into account the annual wage growth, something that would increase our private pension even more, but, even being conservative, our private pension beats the Welfare State.

Let’s compare our private low income pension with the average public pensions in the EU: Spain and Greece had in 2010 an average public pension of 975€ and 696€, respectively. Our private low income pension even beats the higher public pension of EU-15 (Denmark) which increases to 1,548€ monthly.

The difference between our private pension and the public one is even more remarkable taking into account that taxes paid by all the population are more than 35% of the income, counting direct and indirect taxation. In Spain, for example, an income of 15,500€ (1,300€ monthly) pays 9,000€ taxes annually counting direct, indirect and social contributions. And a taxpayer who has a gross income of 18,283€ pays 5,102€ as social contributions. Only with 50% of these taxes, any person could finance our private pension.

In conclusion, despite the widespread belief that a low income household cannot achieve a minimum retirement pension for living after 65 years old, the reality is that any single person (even the ones with low earnings) would be able to have a better retirement by saving his own money than by getting it from the social welfare and by the taxes of the rest of the citizens.

Source| ProRealTime, Seguridad Social, DQYDJ.net, Libremercado

More info| Una revolución liberal para España

Image| Retirement, statistic table (elaborated by the author)

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Legal Intern at Garrigues

Double degree on Law and Business Administration at Pablo de Olavide University.

Participant in Moot Madrid 2014 on International Commercial Law and International Arbitration.

Erasmus Programme at Nicolaus Copernicus University (Torun, Poland).

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