Guide - The Illiquidity of Pension Plans

Why can't I withdraw my money from my pension plan whenever I want? Illiquidity has hidden advantages: it protects you from impulsive decisions and maximizes compound interest. Discover how it works.

1. What Is Pension Plan Illiquidity?

Liquidity, as understood in economic language, represents the ability of an asset to be converted into cash immediately without significant loss of value. In this way, the Pension Plan (in any of its types: Individual or Employment) is classified as an illiquid asset, since the saver cannot convert their rights immediately—that is, the accumulated savings into available money in their bank account.

2. What Are the Ways to Make It Liquid?

Pension Plans are long-term savings vehicles whose purpose is to transfer money contributions over time, which, if properly invested, generate favorable returns thanks to compound interest. The money contributed, along with the interest it generates, is reinvested, making the total capital on which interest is earned increasingly larger.

The time transfer for which the pension plan is designed primarily refers to retirement, the moment when the generated savings can be withdrawn. This product was conceived to be withdrawn when the saver is no longer working, understanding that at that point it will be favorable to obtain an additional source of income. However, the law also considers other situations in which pension plans can provide coverage for the individual's economic situation: disability, death or severe/great dependency, long-term unemployment, and serious illness.

GOOD TO KNOW: Additionally, from January 1, 2025, a new situation for withdrawing accumulated savings comes into effect. The redemption of contributions with at least 10 years of seniority is permitted. That is, on January 1, 2035, contributions made up to that same day in 2025 can be redeemed.

3. What Are the Advantages of Illiquidity?

Just as when a person decides to keep cash in a safe or maintain it in a current account, when we decide to use a Pension Plan we are also making an investment decision. In these situations, the most important thing is to have adequate information about the implications of each decision and, if we also choose to contract a service, to know what the financial product in question entails.

But beyond that, it is worth keeping in mind that as human beings we are conditioned by psychological mechanisms that intervene in those decisions—mental processes that affect investment decision-making and lead to possible errors or biases in our thinking that can influence them. This is what is known as Behavioral Economics.

Illiquidity creates the impossibility of withdrawing invested capital at any time. That is, it reduces the control we have as people over our money and limits it to being able to move savings between different pension plan providers. Therefore, pension plans are instruments that by their nature possess a long-term investment strategy that also allows savers to overcome the two main investment biases related to time horizon:

Loss Aversion Bias

This translates into considering that losses weigh more than gains. That is, the fear a person may have of losing represents a greater incentive than the possibility of gaining something of similar value. This bias applied to time horizon can lead to the so-called myopia effect, which is especially harmful for long-term investors. It causes a person to continuously evaluate their portfolio value and overreact to news and events that occur in the short term.

Myopia disappears in the Pension Plan because illiquidity means the investor does not lose perspective on their investment in the face of possible events that would affect their decision-making. Market ups and downs, which are completely normal, may have caused the total money invested at that moment to be less than the sum of all contributions. In this way, the saver avoids the potential losses that occur when withdrawing money, and by leaving their money in the Plan, it continues to pursue its objective—not only recovering the initial amount but increasing its value over time.

Hyperbolic Discounting Bias

This is conceived as the tendency to choose smaller, immediate rewards over larger rewards further away in time. This is because psychologically the immediacy of rewards has a great power of attraction.

With the Pension Plan, the hyperbolic discounting effect disappears because the saver cannot undo that long-term investment suited to their profile. This situation arises from the constant exposure of a person to suggestive information such as successful stories of sudden wealth or "the last great opportunity to get rich." The typical reaction would be to alter the initial objective of allowing savings to grow gradually thanks to the accumulation of reinvested interest.

Pension Plan illiquidity thus serves as a protection mechanism, helping savers stay committed to their long-term investment goals and avoid common psychological pitfalls.

4. Taxation

When making the pension plan liquid, we are taxed on the general income tax base as employment income. The rate, according to state scales, ranges between 19% and 47%.

Income Tax Brackets:

The law allows withdrawal from the moment the retirement contingency is met, but it can be postponed at the individual's discretion. Along these lines, the most advisable approach is for the saver to withdraw the Pension Plan capital during the stage when they receive the lowest income. That is why it is never recommended to withdraw it in the same year the person retires.

For example, if the pension plan is withdrawn while receiving the public pension, generally fewer taxes will be paid because the public retirement pension is lower than the salary one receives as a worker, so the tax rate applied is lower.

5. Practical Implementation

Unless the person's economic situation strictly requires it, as may be the case with early withdrawal exceptions, it is not advisable to withdraw all the pension plan capital at once, because it is very easy for the marginal income tax rate to be at the maximum, resulting in unnecessarily overpaying taxes. Additionally, the saver should check whether their Pension Plan has an early withdrawal fee.

When those exceptional withdrawal cases require pension plan coverage, one must consider whether the individual has other income. If they have no other income, the most interesting approach is to redeem annual amounts that do not exceed €12,000 to avoid having to pay taxes.

In any case, the saver also has the authority to decide how they want to withdraw their money. Once any of the circumstances are met, and with the particular conditions that each pension plan contract may include, you can recover your pension plan in several different ways:

Lastly, it is worth remembering that a person cannot be both a participant and a beneficiary of a pension plan, so they cannot collect from their pension plan while still making contributions.