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The third pillar of retirement of Switzerland is entirely optional. Your contributions will be locked until retirement. But you will get a significant tax cut from your contributions.
So, should you contribute to your third pillar every year? Before, it was obvious to me. I have always contributed as much as I could into my third pillar. But recently, several people have asked me if they should invest the maximum every year.
Even though there is a large tax advantage to the third pillar, there are also some disadvantages with the third pillar. Do the benefits outweigh the disadvantages?
I answer this question in detail in this article.
Third pillar Advantages
If you are not yet familiar with the third pillar, I have an entire guide on the third pillar.
All contributions to the third pillar are voluntary. They are entirely optional.
So, why contribute to your third pillar? Contributions to the third pillar can be deducted from your income. These deductions will make a significant difference to your taxes.
You can contribute a maximum of 6883 (in 2021) per year in your third pillar. This amount is the maximum that will be tax-deductible. And there is no advantage in contributing past this point.
How much exactly you will save in taxes depend on your marginal tax rate. This rate is the tax rate at which extra income is taxed. It will depend on how much income you have. Generally speaking, the higher your income is the higher your marginal tax rate as well. For many people, this will be between 20% and 40%.
So, if your tax rate is 20% and you contribute 6883 to your third pillar, you will save 1376 CHF the year of the contribution. If your tax rate is 40%, you will save 2753 CHF.
You can view third pillar contributions as an investment with a return based on your marginal tax rate.
When you withdraw the money, you will still pay taxes on it. But this will be at a reduced rate. How much you will be taxed will depend mainly on two things: the amount of the withdrawal and the place where you live.
There is a second tax advantage for your third pillar contributions. You will not pay any wealth tax on the amount accumulated in your third pillar. If you were to keep this money in a bank account, you would pay a wealth tax.
If you have significant wealth, this can save you some money. It will depend on where you live. Indeed, in Switzerland, the wealth tax is different from state to state.
Overall, this could be savings from 0.1% to 1.0%. For most people, this will be on the low side of things. However, compared to the first advantage, this second advantage works every year. So, if you are investing for your retirement in 40 years, this could make a significant difference!
So, the advantages of the third pillar are in the tax advantages it provides.
Third Pillar Disadvantages
Now, there are some disadvantages to contributing to your third pillar.
First, all your contributions will be locked in the third pillar account until you can legally get this money. Generally, you will not get it before retirement age. But this money can also be used to buy a house or start a business (only if you then become self-employed). And if you leave Switzerland for some countries, you can also withdraw this money. But in general, we should assume that this money is not made to be used.
The second disadvantage is that the returns on the third pillar are not as high as on your broker account. We have access to pretty good third pillar providers in Switzerland (here are the best third pillar accounts). But still, some rules limit the allocation of stocks you can have. And it also limits the allocation of international stocks that you can invest in.
Nevertheless, this is much better than the second pillar, where you can expect very low returns. Overall, you probably lose between 5% and 10% in returns. But this is only true if you are aggressive in both your broker account and your third pillar. If you are comparing cash and your third pillar invested in stocks, the third pillar will get much better returns. We need to compare apples to apples.
Now, the most significant disadvantage is the higher fees! It is where the second pillar loses to DIY investing. The best third pillar accounts have about 0.50% TER. This TER is significantly higher than a DIY portfolio with between 0.10% TER and 0.20% TER.
On top of these fees, we will probably lose on the tax-efficiency of U.S. ETF (if you invest in them). Most third pillars in Switzerland do not invest in U.S. ETFs. They will probably invest in fee-efficient Swiss funds. It means that they are losing on dividend withholding. Now, this also means that they get even better TER (sometimes 0%) by using pension funds. Depending on your allocation to U.S. funds, this could account for another 0.05% to 0.1% loss compared to your ETF portfolio with U.S. Funds.
Now, since 2020, third pillar providers are allowed to get back this source withholding of the dividends by the U.S. For now, not every third pillar has taken advantage of this. But Finpension 3a and VIAC already implemented this optimization! So, by using them, you will get more returns than other equivalent third pillars!
Finally, contrary to DIY investing, your capital gains will be taxed. Indeed, when you pay the withdrawal tax, you will pay it on the entire capital, not only the money invested.
So, the disadvantages of the third pillar are mostly its slightly lower returns and significantly higher fees. The fact that it is locked should not matter too much since you will need money in your retirement.
Comparison with DIY Investing
So, with these disadvantages and advantages, let’s see if you should contribute to your third pillar.
First, I am going to compare it with DIY Investing. It is what I am doing with my invested money. And this is what I recommend.
For this, I am going to assume a 5% return per year on the stock market. And the DIY Investing portfolio will have a 0.20% TER. You could go lower than that, but it is a reasonable average for many people. In both cases, I am going to consider aggressive portfolios fully invested in stocks. I am going to consider a yearly 0.05% wealth tax.
As for the third pillar, I am going to take Finpension 3a into account. It is currently the best third pillar available to acknowledge. The fees will be 0.44% with the most aggressive strategy. The money saved with the tax relief is invested in stocks in the DIY Portfolio. I am going to assume 4.8% yearly returns for the Finpension 3a portfolio.
Let’s see what happens if you have ten years in front of you with different tax rates.
So, with ten years in front of you, it is quite interesting to invest in your third pillar. The direct returns of the first year make a significant difference.
Now, we can see that after ten years, the third pillar with 10% tax returns is at the same level as the DIY stock portfolio. However, 10% is a very tiny marginal tax rate. You would need to earn a tiny income to have such a low tax rate. For instance, even with one salary, we have more than 30% savings from the third pillar. And some people can go all the way to 40%. So, we should not be concerned.
As long as you have more than a 10% tax rate, you should invest in the third pillar!
But what happens with a longer period? Let’s see what happens for 20 years.
After 20 years, the DIY stocks pass the 10% tax rate significantly. But the third pillar is still better as long as you have about a 15% tax rate. And this is still low.
Finally, let’s check the results after 30 years:
It is really interesting that even after 30 years, the third pillar with a 20% tax rate still beats a DIY Stocks Portfolio.
So, even if you are investing in your own cheap index ETF portfolio, the third pillar is still a very interesting investment because of the tax returns. But, indeed, the difference is not huge because of the lower yields and higher fees of the third pillar.
Nevertheless, it is still significant. After 20 years, you would still have about 2’600 CHF extra with the third pillar with a 30% tax rate. So, in the end, it will depend on your tax rate, your wealth tax rate, and the returns of your portfolio compared to your third pillar.
Comparison with a Robo-Advisor
Now, if you invest with a Robo-Advisor, should you still contribute to your third pillar?
Let’s see. We are going to keep the same parameters for the third pillar as for the previous example. However, the money that is saved by the tax returns is invested in the Robo-Advisor.
For the comparison, I am going to assume you use the cheapest Robo-Advisor from Switzerland, True Wealth. With an aggressive portfolio at True Wealth, you will have around 0.65% fees per year. I am expecting the returns of the portfolio to be the same as the stocks (5% per year). And I am expecting Finpension to be at 4.8% per year. If you are using a more expensive Robo-Advisor account, the results will be lower for the Robo-Advisor.
Again, here are the results for ten years:
Even with the lowest tax rate (10%), you still have a benefit over the Robo-Advisors outside of the third pillar. So, even if you use the cheapest Robo-Advisor in Switzerland, you still have a good reason to invest in the third pillar.
Let’s directly skip over to 30 years period:
Over 30 years, the differences are more significant. After 30 years, you have gained 5500 CHF more with the third pillar than with a Robo-advisor.
The results are quite logical. An excellent third pillar has very few disadvantages compared to a Robo-Advisor. The returns may be slightly lower. But the fees of Finpension 3a are better than the fees of the best Robo-Advisor! So, the initial tax advantage is better than the difference in returns.
So, if you are investing with a Robo-Advisor, you should contribute to your third pillar! The difference is significant. The best third pillar is better than the best Robo-Advisor.
Comparison with not investing
Just for the sake of it, we can also compare it with not investing your money.
It means that the money you do not invest in your third pillar is left in a savings account. For this savings account, we are going to consider 0% returns and 0% fees. You may have a fee on your bank account these days.
Let’s see what would happen after ten years:
The results are pretty obvious! If you are not investing your money, you should invest what you can in the third pillar. Contributing to your third pillar will make a huge difference!
What if you have a third pillar in cash?
Some people have a third pillar in cash. These accounts have very low returns but usually have no fees. So, how do they compare with the other means of investing?
Before I make the comparison, I would like to emphasize that I do not recommend these third pillars. The only time where it would be adequate is when your retirement is very close.
So, we can take a third pillar account with 0.3% interest as an example of this analysis.
First, let’s compare it with a DIY Stocks Portfolio:
In less than ten years, the DIY Stocks portfolio will outperform the third pillar, even with large tax returns. This result is expected because of the much larger performance of a DIY Stocks portfolio compared to a cash third pillar.
So, if you only have access to a cash third pillar account (unlikely!) and you are a DIY Stocks Investor, you should not invest! The exception would be in the last few years before your retirement. But I do not see how an investor would invest in such a third pillar.
Let’s see if the same holds when compared with Robo-Advisors:
We get almost the same results as with the DIY stocks portfolio. If you invest in stocks in a Robo-Advisor, you should not invest in a third pillar in cash.
Finally, let’s see what happens if you invest in cash:
In that case, we still have enough advantage with the original tax returns to make it worthwhile.
Now, I will have to repeat myself: you should invest in stocks in your third pillar if your risk tolerance allows it. And ideally, you should invest in stocks in your primary portfolio as well.
So, now we can answer the question: should you contribute to your third pillar? Yes!
If you contribute to a good third pillar with low fees and high returns (Finpension 3a probably), the tax advantages of the third pillar will outperform even your DIY Stocks Portfolio.
And the third pillar gets better as your income grows. If you have a substantial income, you have no excuses not to contribute to the third pillar.
With an aggressive DIY portfolio, the difference is not huge, but it is still significant. But if you are investing with a Robo-Advisors, the third pillar is going to be even more investing. And if you are not investing at all, the third pillar will be your best investment!
And in some cases, it is true that the third pillar is not really worth it. If you are in a canton where withdrawals are heavily taxed, it is possible that the tax on the capital gains outweighs the benefits of the tax benefits. But that is unlikely, for most people, it is still interesting to contribute to the third pillar.
Now, of course, you will not gain much by investing in a third pillar in cash. You need to invest in a good third pillar for the long term.
If you do not know where to start, check out my guide on how to start investing.
What about you? Are you contributing to your third pillar?