Are Spanish private pensions a waste of money?

I have just been researching Spanish private pensions for an article on our main website ("Tax treatment of Spanish private pensions") and it left me feeling somewhat depressed. The system is supposed to encourage private pension provision by making the contributions tax free but, having dug into the topic, I wouldn't touch a Spanish pension scheme with a bargepole. How come?

If you focus solely on the tax benefits then you may well ask “what’s not to like?”. You can offset up to 10.000€ year against taxable income and you save your highest rate of tax – up to 43%. It gets even better for over-50s who can offset 12.500€ annually. But when you consider what happens once you have signed up to a pension plan and paid over your contributions, then the warm feeling generated by the tax saving starts to wear off. Here are the issues:

1) Barring some minor exceptions, your money is well and truly tied up until the normal state retirement age (65 and rising)

2) When you retire the accumulated fund can be taken as income or capital in a variety of different ways (lump sum, draw-down, annuity purchase) all of which are taxable like any other income. There used to be some tax deductions for pensions income taken from these plans but these have been scaled back.

3) Most of the pension plans I have seen charge 2% a year for administering your pension plan

Think about these drawbacks a different way – you don’t take out a personal pension plan and do your own savings. Ordinary (as opposed to pensions) savers won’t get the tax benefit of offsetting pension contributions versus taxable income and will have to pay tax on the investment income and capital gains on their savings. But on the other hand savers can invest their money themselves, avoid the 2% annual charges and draw down their savings when they like without paying income tax when they do so.

This last point is very important when comparing pension plans with ordinary savings and investments. You pay tax in both cases: pension plans save you tax initially and as you build up your returns but you pay tax when you retire on everything accumulated; ordinary savers get no tax relief to begin with and pay tax on their investment returns but don’t pay later on. You will really only gain if you pay higher rate taxes during your working life but pay the lower rate in retirement; not an uncommon situation as people mainly have lower incomes when they stop working but still food for thought. People who pay the same rate of tax pre- and post- retirement should think of pensions tax relief as “tax deferred” rather than “tax saved”.

And what about those charges? 2% may not sound so much but it is extremely significant both because it is high in terms of the returns available to most investors and because the effects are magnified over time. Additionally plan providers take a 0.5% commission on contributions as they are made to the plan. Also the underlying funds which the contributions are invested in may make charges which reduce the investment returns.

If pension plans were returning 8-10% a year, then a 2% annual management fee would not be so noticeable but when returns are down to today’s negligible levels, it makes a big difference. A 10 year government bond for example can yield as little as 2% today and the FTSE 100 yield is about 3%. Riskier assets yield considerably more but the risks to capital are greater. Inflation has recently been depressed by the recession but has been running at 3-4% in Spain. So with management charges and inflation eating away at capital, the underlying investments have to do very well (e.g. make 6%) just to stand still.

And how do the pension plans perform? Well there are literally hundreds but the ones I looked at didn’t inspire much confidence. For example La Caixa’s flagship fund “Nacional” would by my calculation have seen investments shrink by 7% (even before taking inflation into account) during the last 5 years. CajaMadrid charge 1% a year for their safest, fixed return funds but this has returned a measly 7.5% over the last 5 years, scarcely enough to cover the charges and a big loss after inflation. Their international fund (2% charge) has lost 32% in 5 years.

All in all it looks like Spanish pension plans are good for the banks who sell them but are to be treated with extreme caution by anyone who doesn’t fit a certain tax profile.