EKIP– Expert Club for Economics and Politics A Different Opinion
As we have explained many times in the EKIP, the pension system is bankrupt. And we offer some solutions to this problem. "So far so good," at least some of you are surely saying to yourself, "but what can I personally do about it?". "How can I take care of my financial well-being in old age in such a situation?". Very important and relevant questions. However, even if you support our campaign for pension reform, this will not solve the problem here and now and secure your financial future. Therefore, in this article, I will introduce you to 3 investment alternatives to the mandatory pension system, which you can take advantage of, here and now, to secure your old age.
1. Voluntary pension funds
The first alternative, of course, are voluntary pension funds. The most obvious advantage of these funds is that they are also the easiest and simplest alternative to mandatory insurance. These are funds that aim to follow investment strategies that are most suitable for pension insurance purposes. This is a big plus for people who do not have the time to study the different investment strategies of the many investment funds in the private sector or to prepare their own personalized investment portfolio. Voluntary pension funds are the easiest and most straightforward alternative to mandatory insurance.
One significant advantage that these funds have is their lower fees compared to those of universal and occupational funds from the second pillar of the pension system (the voluntary funds themselves are classified as the "third" voluntary pillar). Also, voluntary pension funds often achieve higher returns than the universal and occupational funds that form the second pillar. In 9 of the last 13 years, voluntary funds have achieved better returns, as a result of which both their average and median returns for the period are higher than those of universal funds. In the graph below you can see a comparison between the average returns of voluntary and universal (mandatory) private pension funds for the period 2007-2017.
Source: FSC
Of course, if you search through the investment funds on the market, you will certainly find those that offer products with a similar risk profile and higher returns at a similar (or even lower) price, but the problem is that they are not easy to find. However, finding such investment funds requires not only additional time and effort, but also some knowledge of financial and investment topics. With voluntary pension funds, it is much easier. It is immediately clear to you what you are getting – a conservative investment product with a return noticeably lower than the market, but also with much lower volatility.
Another advantage of voluntary pension funds is that when you contribute money to them, you can take advantage of a tax break. According to the law, when social security contributions for a voluntary pension are paid from the salary or any other type of remuneration, the employee is exempt from tax in a certain amount (up to 10% of taxable income) according to the rules set out in the Personal Income Tax Act. For example, if you have a salary of 1,000 leva and 100 leva of that goes to social security contributions to a voluntary fund, these 100 leva are exempt from tax. This way, you will only pay income tax on 900 instead of 1,000.
2. Mutual investment funds
In second place come mutual investment funds. These are not specifically pension funds, but they are still investment funds that in many cases offer investment products that can serve pension purposes. However, more attention is required here because not all investment funds on the market are suitable for pension needs.
First of all – watch out for the level of fees. The biggest killer of investment returns are fees and transaction costs. Don’t make the mistake of blindly chasing the best-performing mutual fund on the market. Just because a fund has made more profit than all the others doesn’t mean it brings the most profit to its clients. Simple math – which fund brings more money to its clients: the one that makes an average annual return of 8% with 2% fees or the one that makes a 7% return with 0.7% fee? The answer is the latter, because 6.3% is more than 6.0%. Always consider your personal (nominal) return, which is equal to the nominal return of the fund itself MINUS any fees you pay for it.
Secondly, be careful about the investment structure of the fund you buy. Invest in funds with an investment structure that matches your personal risk profile. An advantage of mutual funds over voluntary pension funds is that they have more diversity in this regard. This allows you to find a fund whose investment structure is relatively more suitable for your individual needs. In pension funds, they all follow the same strategy in general – a roughly similar ratio of debt (bonds) to equity (shares) instruments.
However, this is not always the right approach because the individual risk profile of the individual insured person is not taken into account. For example, your risk profile is very different when you are 30 and when you are 60. And besides age, there are a bunch of other variables that determine it. We can’t go into this topic in depth here, but here is a simple rule of thumb that you can follow – when determining what percentage of high-risk (capital) assets you can tolerate in your investments, simply calculate 100-X, where X is your age. The result tells you what percentage of high-volatility (capital) assets like stocks you can tolerate in your investments. The logic is clear – the younger you are, the more volatility you can tolerate, because you have more time to compensate for any potential losses in the years leading up to retirement.
3. Personal investment account
Third, last in order (but not in importance), comes the personal investment account. This alternative is the most complex, because it requires you to prepare an investment strategy yourself (or together with an advisor) and implement it with the help of an investment intermediary. As you might guess, this requires much more time, knowledge and effort than the previous two options. But it is also the most flexible option, because it allows you to maximally adjust the investment of your retirement savings according to your personal preferences and circumstances.
The rules about fees and risk profile I mentioned above regarding choosing a mutual fund apply here as well. Be especially careful about fees when trading through an investment broker. These can very quickly (and imperceptibly) not only eat up a large portion of your profits, but can even put you in a loss. The good news is that the easiest way to build an individual investment portfolio is also the cheapest in terms of such costs.
If you choose this option, try to keep your investment strategy (and therefore your portfolio structure) as simple as possible. You can build a good portfolio by investing in just 3 passively managed, exchange-traded funds. The share prices of these funds: First part in an index fund (ETF) that tracks a large stock index (such as the S&P500), second part in an index fund that tracks the movement of a debt index such as government bonds, and third part in a gold ETF that tracks the movement of the price of gold. The exact allocation of your money depends on your risk profile. I already mentioned a simple rule above that you can follow when determining the percentage of investments in stocks.
Keep in mind that gold is a more volatile investment asset than government bonds. So if you're looking to minimize the volatility of your returns (and therefore the likelihood of making losses in a given period), the money you invest in gold should not exceed that in government securities. And if you invest in exchange-traded index funds, try to choose those with the lowest management fees (ideally 0.20% or less). The fees of these passively managed funds are usually much lower than those of actively managed mutual funds, which is a pretty big plus.
Don't stop educating yourself!
In short, these are the three main alternatives to the (failed) mandatory pension insurance in Bulgaria. I hope you have learned something new and useful within the above lines. Of course, this article is not completely comprehensive, because its purpose is to act as an introduction. I recommend that anyone interested in any of these options learn more about the topic - there are many sources on the Internet on this topic. Our podcast "The Intelligent Investor" (especially episodes 1 to 10) is a good start. Never stop educating yourself!
