Is it worth it to add to your second pillar?
Some pension funds offer the possiblity to make voluntary contributions to the second pillar. In most cases, it’s also possible to “cover the hole”. But is it a good idea?
When it comes to retirement planning, there aren’t many levers to pull in Switzerland. Essentially, there are two choices to be made:
- Should I open a third pillar?
- Should I put more money into my second pillar?
But question 2, not so much. So here we go…
What is the second pillar?
The second pillar is a locked savings account that is invested by a pension fund selected by your employer. Every month, whether you want it or not, your employer and yourself wire automatically a percentage of your earnings to that account. And every year, your account is credited with a certain yield (nowadays, between 1 and 2%).
The state decides what the minimum contributions are but each employer is free to go above those minimums and offer more generous pension plans.
How can I really put more money into my second pillar?
There are two ways to put more money into the second pillar:
1) The pension fund lets you make a voluntary contribution on top of the mandatory contributions (mechanism 1) Not all pension funds allow it.
2) You have a « hole » in the second pillar (mechanism 2)
Mechanism 1 is straightforward to understand: you may decide to put an extra 1, 2, 3, … X% of your salary in the 2nd pillar account. For instance, my pension fund allows for either 3 or 6% extra contributions.
Mechanism 2 is a bit trickier. Imagine that you come to Switzerland at age 30 and that you earn 80k a year. Since you didn’t contribute to your second pillar between age 25 and 30, there is a hole in the second pillar. The hole is what is missing compared to how much money would be there had you started to contribute at age 25. That’s the first way to have a hole.
The second way is when you switch employer and it is more generous than the previous one in terms of second pillar contributions. So, even if you started to contribute at age 25 and didn’t have a hole according to the previous pension fund, you now have a hole according to the new one, because it calculates how much you would have had if you started contributing there from the start.
One example: let’s say Paul worked at company A between age 25 and 30 and contributed a total of 50k during those 5 years, or 10% a year, neglecting the interest. Let’s imagine that company B is more generous than company A and offers 12% contributions. So if Paul had contributed to the pension fund of company B, he would have had 60k after 5 years, again neglecting the interests, and not 50k. So, when Paul switches from company A to company B, he has a hole of 10k in his second pillar.
That also happens if you stay at the same company but your salary increases.
Why is it interesting to put more money into the second pillar?
There are two advantages:
1) By putting more money into the second pillar, you get a higher pension down the line.
2) This money is deductible from your taxable income that year.
So, let’s say that Paul decides to actually pay those 10k into his second pillar, he won’t be taxed on those 10k. If his marginal tax rate is 20%, it means that he is saving 2k in taxes that year so putting that money aside will only cost him 8k.
Why is it less interesting to put more money into the second pillar?
We first have to differentiate between mechanisms 1 and 2. Mechanism 1 is like renewable ressource: it doesn’t consume anything. On the other hand, mechanism 2 is like fossil fuel: once it’s used, it’s gone. Because once the hole is covered, there is no more hole to cover.
In that way, voluntary contributions (mechanism 1) is very similar to a third pillar: you’re allowed to contribute and it does confer some advantages, but there is no obligation. The difference between mechanism 1 and the third pillar is that you don’t get to choose how the money is invested: the money will get managed by the pension fund and you will get your 1-2% a year on it. Whereas a third pillar can now be invested in stocks, bonds, real estate and even gold, providing potentially higher (yet less consistent) returns. So, the first drawback is that the money is locked in an account that only provides 1-2% a year. So there is a large opportunity cost.
The other drawback is that if you’re planning on using your second pillar down the line for the deposit of a mortgage, you’re essentially transforming hard cash into soft cash (more details here).
So, is it worth it?
Let me first tell you when it’s definitely not worth it: don’t use mechanism 2 unless you’ve already maxed your third pillar and mechanism 1 for the year. First use the renewables, then the fossil fuel.
Now, should you use mechanism 1 at all? It’s not a terrible idea if you pay a lot of taxes and if it’s not consuming all your capacity to save money.
To put it more concretely: if you’re saving 2000 francs a month and investing it in risky assets like stocks, and have a 33% marginal tax rate, it’s not a terrible idea to put like 150 francs a month as voluntary contributions into the second pillar. It gives you an immediate tax benefit and doesn’t compromise your wealth building because a decrease from 2000 to 1850 is marginal.
Now, if you’re only saving 200 francs a month and have a 15% marginal tax rate, don’t divert 150 francs per month to your second pillar. The tax savings is minimal and most importantly, it lowers to investing to 50 francs a month, which is too low to achieve any significant wealth.
Here is what I would do for mechanism 2
If I had a significant hole in my second pillar, I wouldn’t cover it… yet. I would carry it until let’s say 5 years before retirement. And then aggressively fill 20% of the hole each year.
Why? Because I’m hopefully going to earn more money when I’m 60 than I’m earning now, so the tax savings are going to be higher. And since it’s a one off, I better get the best deal out of it.
The other reason is that I minimise the opportunity cost: by locking the money at 1-2% for only a couple of years, I only « losing » 5-6% a year for a few years, not for 30.
Let me explain what I mean by that: I’m 33, so I’m 32 years away from retirement. If I invest 1000 francs at 1% now, I will have 1375 francs 32 years from now. If I invest 1000 francs at 7% now, I will have 8715 francs 32 years from now. So, by choosing to invest at 1% instead of 7%, I’m « losing » 7340 francs. Of couse, it’s a virtual loss. I’m not actually losing anything. But I’m having less than I could have had ; that’s opportunity cost.
Now if I were 60, and therefore 5 years away from retirement, that virtual loss on those 1000 francs would only be 352 francs. So I’m much better off reducing that time as much as possible.
So why not reduce it further? Why spread the buyback on 5 years? Why not covering the hole in the last year?
1) Depending on the size of the hole, I may not be able to cover it all in one year.
2) Even if I had the money, the tax savings are diminishing as the money invested increases: since taxes are progressive, I’m only saving the marginal tax rate on the edge of my taxable income. But if I cut my taxable income in half because I’m covering a 50k hole in my second pillar, I’m saving much less than I could.
3) Doing it all in the last year might be interpreted as tax evasion, especially if I end up taking some of the second pillar as capital. So, I would rather pay a higher opportunity cost than to have my buyback annulled with a fine on top.
If my marginal tax rate is 35%, I’m essentially getting each of those 5 years a 7% return in the form of tax savings on top of the 1-2% performance on the second pillar account for my first investment. All this guaranteed. That’s a good deal. Sure, I’ll have to pay taxes eventually because the second pillar pension is taxed as income but it will be lower.
There is no one-size-fits-all answer to the question: should I put more money into my second pillar?
But here are some pointers: don’t cover the hole in your second pillar unless you’re already maxing out your third pillar contributions and voluntary contributions to the second pillar. Instead, keep the hole for later, when you’re close to retirement. That way, you will get similar of higher tax savings and a lower opportunity cost. At this point, it’s definitely worth covering the hole.
Now, for the extra voluntary contributions, do it if your tax rate is high and it doesn’t compromise your wealth building. A good rule of thumb is 10%: if the voluntary contribution represents less than 10% of your total savings, it’s not a bad idea. If it’s more, keep saving outside of the traditional pillars.