Should you contribute to your second pillar ?

Posted on Categories FIRE, Investment, Switzerland
Should you contribute to your second pillar?

In Switzerland, you can do a voluntary contribution to your second pillar. The second pillar is the Swiss equivalent of a 401(K). These contributions come with some tax advantages since you can deduct that from your income. Therefore, you have a return equal to your marginal tax rate. However, the money is then blocked into the second pillar. And the returns on that blocked money have been very low in recent years. Finally, you can only withdraw the money from your second pillar if you retire, if you buy a house or if you start a company.

One question that I actually ask myself these days is whether I should contribute money to my second pillar or continue investing in stocks. These days we are able to invest enough money each month that I am wondering about this. I could contribute some money to my second pillar and continue to invest enough in stocks. But is it a good solution. In this post, I am going to try to answer this question.

Second pillar contribution

So how does a voluntary contribution works? Normally, you pay each month some amount of your salary to the second pillar. And this is matched by your company. You do not have a say in this. So there is no way to optimize that.

However, you can contribute some amount yourself to cover the holes in your second pillar. If you had a low salary when you started, you are sure to have holes in your contributions. When you do a contribution, you can deduct it from your taxes, just like the third pillar. How much a reduction in taxes this will realize is difficult to calculate properly. It depends on your marginal tax rate. This will depend on your income, your wealth and where you pay your taxes. In most cases, this will be something between 30% and 40%. That means that the immediate rate of return of this contribution will be 30% to 40%. This is a form of investment.

Now, the invested money will be blocked until you can take it. We have seen in the second pillar post that there are only four cases when you can take this money out: building a house, starting a company, retiring or leaving Switzerland. In that cases, you will lose out a part of the second pillar as taxes. But this is not as much as your marginal tax rate. And voluntary contributions are always blocked for three years.

As long as it is inside the second pillar, your money will get some interest. Unfortunately, the interest is currently extremely low now. You can expect about 1% interest in most pension funds in Switzerland. Nevertheless, it is a safe interest for now. It cannot go down.

Scenarios

The obvious alternative is to invest it in stocks. So we can check how will the same sum behave if invested in stocks or contributed to the second pillar. First of all, let’s run some scenarios to see how that works.

Let’s start with a return per year of 3% for the stocks. For the second pillar, we are going to consider 30%, 35% and 40% marginal rates. The current interest rate on most second pillars is 1%. So we will take that as the reference. Here are the results for twenty years.

Second pillar vs Stocks (3% per year)
Second pillar vs Stocks (3% per year)

As you can see, it takes 13 years for the stocks to catch with even the smallest marginal rate. And it takes about 17 years to catch with the largest marginal rate. In that case, even 3% return per year on the stocks is slow to catch up with the very large interest as a tax deduction. But generally, stocks are returning more than 3% per year. So let’s see what happens with 5% return per year.

Second pillar vs Stocks (5% per year)
Second pillar vs Stocks (5% per year)

This time, it takes less than 10 years for the stocks to go up as much as the second pillar. And they are ending up much higher. This is the power of compounding. Even 5% per year can return a lot in the long run. This is what I personally expect from the stock market. Even if I started at a terrible time since I actually lost money in more than one year. But this is how the stock market and I am prepared for this. You can only expect average return going up over the long term. Now, some people are counting on about 7% of return per year. So, let’s see how that will go:

Second Pillar vs Stocks (7% per year)
Second Pillar vs Stocks (7% per year)

With 7% of stock returns per year, the return on the second pillar contributions is dwarfed. Compounding gets stronger and stronger as the returns increase. After twenty years, your stocks will be worth more than twice your second pillar contribution.

Based on this uniquely, one should probably not invest in the second pillar. However, there are other considerations. First of all, it will depend on the term of your investing. If you are investing for the really long term, it is probably better to stick with stocks. But if you are to soon get access to your second pillar, it may be a very strong investment. This could be if you are going to retire soon or if you are going to build a house or start a company.

But, do not forget that voluntary contributions are locked for three years. So if you intend to buy a house in the next three years, you should not invest in it.

The other consideration is whether you need bonds or not.

Your bond allocation

Due to its safe nature and the guaranteed interest rate, I consider my second pillar as bonds. I actually integrate it into my net worth as bonds.

So another reason to buy into the second pillar is depending on your allocation. If your bond allocation is too low for your current allocation, you can do a voluntary contribution to increase it. Given that it also has a nice tax advantage when you purchase, it is probably better than bonds. Especially, it is better than Swiss bonds that have a negative interest rate. If I need to buy bonds, I will contribute to my second pillar.

For instance, here is the current allocation of my net worth:

 

Net Worth Allocation as of October 2018
Net Worth Allocation as of October 2018

As you can see, I already have too many bonds. For now, I do not want to have more than 10% of my net worth in bonds. So it will take a while before I need to add bonds to it. But this shows that contributions to the second pillar can be driven by other things than pure returns.

Conclusion

It is clear from the different scenarios that from an investment point of view, second pillar contributions are not as good as it seems. Even though they have a very large initial return on investment, they have a very little return per year after that.

Nevertheless, they are a good alternative to bonds. They have a guaranteed (at least for now) interest and offer a nice tax reduction. This is something that would be quite interesting to do as one is nearing retirement. But keep in mind that you can only contribute to your second pillar if you have a salary or have your own company.

Personally, I do not think I will contribute soon to my second pillar. I am a bit tempted since I feel that stocks are too high right now and they do not earn well. I would like to wait for the next crash. But this is market timing. So I will refrain myself. These contributions are not a bad investment at all. But it is not necessarily the best investment at all times. Like every other investment, it will depend on your context and your situation. You should consider every element before you decide on any investment. And never take any rash decisions!

What do you think about this? Are you contributing to your second pillar?

8 thoughts on “Should you contribute to your second pillar ?”

  1. My question is if you are only allowed to invest in very low yielding debt instruments in your second pillar, tax-advantages account? Do you not have an opportunity to invest in stocks, mutual funds, ETFs through that account? If you can, tax-advantages stock returns are better than after-tax stock returns, assuming your ultimate goal is a secure retirement. If you’re looking for liquidity and have a more pressing purchase in mind, after-tax is the way to go.

    1. Hello Young (YATI? YI? :) )

      That is a very good question.

      If we could choose the allocation of our second pillar, it would make sense to invest as much money as possible into it. Unfortunately, Swiss second pillars are much worse than 401(k) from the United States. The pension Funds companies are allowed to invest the money as they wish but they only give you very little (1% per year currently) of the returns. This really sucks. But there is nothing we can do.

      We cannot choose what our second pillar money will be invested into. Therefore, it’s not as good an investment as it seems.

      I hope that makes sense

      Thanks for stopping by

        1. I agree, it stinks. There is still the advantage of the initial tax advantage. So I am going to use it if I want more bonds. But for now, my second pillar is already quite big compared to my stocks.

          Thanks for stopping by YATI ;)

  2. Hi
    Thanks for these calculation. Do your charts take into account the tax on payout? (Kapitalauszahlungssteuern)

    Afterall it takes away about 5% of the FINAL value.

    1. Hi,

      No; my charts do not take into account. The final number for the second pillar will be even smaller. Unfortunately, it is difficult to compute how much taxes will be paid on the second pillar.

      But you are right that I should account for that! I will try to update the post to make that more clear

      Thanks for stopping by :)

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