Retirement, 3rd pillar

To be completely clear, I personally think the third pillar is an absolute failure and is essentially the state subsidizing banks that are burning money doing absolutely unreasonable things in terms of fund management. (You might notice that I’m quite disappointed at how badly the system currently works.)

This is obvious from the following statistic:

  • S&P 500 over the last 5 years – +87% (the annualized numbers are impressive as well)
  • Best 3rd pillar fund over the last 5 years is barely touching 9% annualized

Third pillar idea in theory

On paper the idea of the third pillar looks great. You can set aside up to 15% of your gross income (tax-free), so that’s an automatic return of 20% on the money invested. Seems amazing, right?

In theory the third pillar could be an amazing way to motivate people to save up for their future. 15% saved on top of the 1st pillar that comes from the state + the 6% that you get from the second pillar is likely to help you quite a bit in retirement.

Third pillar in action

If you look at the returns on the third pillar for an average citizen then the situation is less drastic than when looking at the funds benchmarked against indexes. The reason for this is the fact that the contributions get put in tax-free and people don’t personally get a feel for the amount of money that the state loses through this.

What this means in reality is that the state is subsidizing banks that are literally burning money. People get OK returns, but this isn’t because of how well the market is doing (and we’ve had three solid years of an absolute bear market which could have made incredible returns even with a relatively conservative strategy). People get returns because the state is “absorbing” a huge amount of the losses that bad fund management is causing.

My personal opinion

As the third pillar is right now, I wouldn’t go anywhere near it. In addition to the way the system works overall, the way you can start cashing out is complicated enough that I don’t see the point.

I think the idea of allowing such a huge amount of tax-free contributions is great. However right now the main benefactors are banks and the biggest loser is the state.

If the third pillar allowed better choices (as with the second pillar, I’d be super happy with just an ordinary index of some sort as opposed to active management) I’d consider it. Right now, however, I see no reason to give away such a huge amount of money for terrible fund management.

I understand that the third pillar would otherwise be a great idea for people who lack incentive to invest otherwise (in some ways it is a relatively safe way to invest). However, as I’m more than OK with making active reasonable choices the third pillar will get little support from me as it is right now.

Retirement, 2nd pillar

While with the first pillar you can do very little to influence the overall results of your retirement, the situation is somewhat different when it comes to the second pillar.

The second pillar is still obligatory but there is a measure of choice about it that will likely end up giving some people much bigger or smaller retirement accounts.

Essentially it’s mandated that 2% of your salary will go into your retirement account and the state will match it with 4% (taking that away from the first pillar), meaning that for all intents and purposes you get 6% into your second pillar every year. It sounds a bit better on paper than the situation is in reality.

Choosing between bad choices

There is a whole wide range of different retirement funds that you can choose from. DIfferent banks offer generally at least 4 funds which are different in terms of their risk level (essentially stock-bonds ratio).

While having the option to choose is great, then it becomes a bit less useful when most choices are just plain bad. The funds have very high expense ratios (though they have gone down a bit), their returns have been abysmal and cashing out of the fund is so complicated and handled by insurance providers that some people will definitely end up having terrible deals.

The benefits and downsides of the 2nd pillar

There are some reasons why I like the second pillar. Mostly because it will force everyone to save some money at least. The first pillar will likely get smaller and smaller as time goes on, so the importance of the 2nd pillar for my generation is quite high.

The second pillar however suffers from a similar problem as the first – it’s heavily dependent on the amount of money you make. This means that people who live in poverty now will also be in poverty in the future. The differences between people’s wealth will carry off into retirement and some parents might end up being incredible financial burdens on their children due to not having enough money in the 2nd pillar.

My experience with the 2nd pillar

2ndpillar

At first I had a terrible 2nd pillar fund that I finally got rid of when I started working full time. The fund I have now is doing OK compared to others on the market, but the net gain over the years is still negative when you take into account inflation. I have little faith that it will ever come close to the stock market’s historic return and I’m a bit saddened that we don’t have the American 401k system where I would be able to make the choices of what to do with my money.

There is a pretty big lack of social discussion about what to do with the 2nd pillar. As it stands now, it’s quite close to being an absolute failure. People don’t believe that they’ll get proper returns and that really keeps them from getting into investing. If you don’t pick your own 2nd pillar fund, then you will get one assigned randomly – that happens to several thousand people every year!

To make the second pillar work, this is what I’d like to see:

– increase the cap for investments (like, maybe max 10%)

– the government match should not come from the 1st pillar

– allow people more individual choice (why can’t I just choose a passive index fund instead of a badly managed active one?)

– drastically lower the maintenance fees to competitive levels with index funds (really, some funds had 2% fees at start!)

– allow for different exit strategies beyond the current insurance contract

Retirement, 1st pillar

The retirement system in Estonia consists of three pillars, making it a somewhat complicated system. The first realization that the system is complicated comes from the fact that it takes me more than one lesson to teach the topic to students. The second comes from my experience of how little people know about the way the system works – how little I knew about how the system worked before I started looking up information on it.

Your future pension payments will come from a combination of three pillars. The first, which is obligatory (which I will be writing about in this post), the second, which for all intents and purposes is also obligatory and the third pillar, which is currently voluntary.

What is the first pillar?

Essentially the state is keeping track of how much you work. The first pillar is dependent on your current salary – the more money you make, the higher your future pension payment will be. At the end of the year the state looks at the amount of money that you have earned and compares it to the average national salary.

If you make an amount that’s equal to the average national salary then the pension “count” for you is 1,0. If you make the minimum salary then it takes approximately 3 years for you to gain 1 year worth of “average” benefits.

The upsides of the first pillar

In theory the first pillar is great – the state takes into account your contributions to society and you will get some money at least when you’re retired. However, this means that 1) the state has to take less responsibility for the lives of the people and 2) 1st pillar means less social support for people who aren’t doing as well as they should.

The main idea of the first pillar seems to be that it will give people enough money to survive. They won’t be rich by any means, but at least they will not be forced to steal or commit other crimes to survive. (In theory, the actual numbers show why this might still be a problem).

The downsides of the first pillar

The first pillar definitely has some problems that come with it. If you know anything about statistics then you see why the idea of basing the 1st pillar on the average salary falls painfully short. This is how statistics work  – the average salary in Estonia is close to 1000€ gross, but, about 2/3 of the people in Estonia make less than the average salary.

Currently I’m above average when it comes to the 1st pillar, but I’m realistic about the situation. The only reason why I’m above average is that fact that I’m 1) living in the capital where the salaries tend to be higher 2) because I have 2 jobs 3) because I’m working overtime. When it comes to an ordinary person then the downsides of the first pillar become apparent quite quickly.

The biggest downside of the first pillar is the logic of how it works. To get the 1,0 count of retirement you need to earn the national average in terms of salary. That’s all fine and dandy in terms of some of the areas – like IT or business. It’s quite a bit more complicated when it comes to people who live outside of the capital and who work at less than ideal jobs.

To some extent the first pillar causes a moral dilemma – if a cashier works for a full year and if a banker works for a full year, do they deserve a similar amount if retirement benefits? For now, the answer in Estonia is no. I think in the future it might be something a bit different. As the world gets more and more complicated, then it’s obvious why the more complicated jobs get paid more and more. However, I think everyone in the world would be unhappy if we didn’t have cashiers or cleaners – and we’re kind of bad when it comes to giving them credit for their work.

Looking at the future of Estonian retirement, it’s painfully obvious that most people are not saving nearly enough to be able to manage retirement. The first pillar will guarantee at best, 25% of you previous salary – that’s not a whole lot. This is the reason why people need to save money on their own – if they don’t, retirement will be a painful and sad affair.

Me and the 1st Pillar

I work as a teacher. Leaving out all of the side projects that I’m involved in, I’d be one of those people whose work “year” counts for less than the average “year”. I’m someone who would like equality to some extent, so I feel that this is truly very unfair.

Currently I’m hovering about the average salary, which gives me the 1 year of work = 1 year of benefits count, but only just. Even so, that will not be nearly enough for a comfortable retirement, which is why having passive income is so important.

It’s relatively unlikely that Estonian pensions will drastically increase in the upcoming decades. The country has such a low birthrate and we’re quite far off from the wealth levels of our Nordic neighbours. If anything, then the pensions might be reduced further or the retirement age bumped upwards. (I definitely do not want to be forced to work until I’m 75!)