Pension Plan or Investment Fund?

The dilemma between choosing a pension plan or an investment fund can be resolved with transparent analysis and clear examples.

1. The Investment Dilemma

The eternal dilemma of whether a pension plan or an investment fund is better can be summarized by saying it mainly depends on 2 factors, as we will explain in this article.

• External Factors: Market and Returns: That is, how much interest my investment generates to know if it's worth not paying taxes and reinvesting them instead. In this case, it's important to look not only at portfolio performance but also at fees, since the lower they are, the more reinvestment capacity they give to the portfolio.

• Internal Factors: Human Behavior: In other words, how we decide to withdraw our savings: at the slightest loss (thus ensuring the impossibility of long-term recovery), all at once upon reaching a certain age...

The first thing we need to do as savers is understand what an investment fund is. We are dealing with a collective investment product (CIS), where basically the contributions of participants (a certain number of people) are pooled to invest their savings. On the other hand, pension plans are a long-term savings product that keeps the saver's money invested through a pension fund. They behave in the same way as investment funds—the investments made can be exactly identical. That is, the assets in which an investment fund and a pension plan invest can be the same: bonds and stocks.

2. Regulation and Supervision

At a formal level, both pension plans and investment funds are monitored by the Bank of Spain, although each falls under a different specific area.

• Investment Funds: Investment funds, along with the entities and managers that administer them, are supervised by the National Securities Market Commission (CNMV).

• Pension Plans: The Directorate General of Insurance and Pension Funds (DGSFP) is responsible for controlling the solvency and policy execution of management entities (which manage the money) and custodian entities (which safeguard the money).

3. What Suits Me Better?

Nobody can give you the answer you're looking for because only you know the details of your personal situation. We're not talking about salary, additional income, age... but about personal factors such as fear of losses, risk aversion, and life outlook. At Arca, we firmly believe in pension plans because only this way can you retain the fruit of your labor and keep it invested instead of handing it directly to the tax authorities, no matter how much they keep saying "we're all in this together."

If you're an employee, you can take part of the salary you receive at the end of the month and place it in an investment fund. That is, once the corresponding income tax has been withheld, decide what portion to save from the remainder. In contrast, the pension plan allows you to act at a prior step—it's a way to avoid only being able to save with what your company deposits in your bank account, since you don't pay income tax on what you allocate to the pension plan, meaning you end up receiving more money between your paycheck and your savings.

Pension plans are a way to defer the taxes you pay into the future, since at the time of allocating money to the plan, no income tax is paid—only when it's withdrawn. It's designed this way because the expectation is that you can move it to a time when your income is lower (such as retirement, or other situations where you face a financially challenging situation). On the other hand, investment funds are taxed as capital gains when capital is withdrawn; however, income tax is also paid upon receiving the money that subsequently ends up invested in the fund.

4. Comparative Example: Fund vs Plan

Let's look at an example. Juan earns €25,000 gross annually, is 23 years old, and decides to save €50 per month in an indexed investment fund. Now he meets Noé, who also earns €25,000 gross annually, is also 23 years old, and decides to save €50 per month in an Employment Pension Plan. To simplify, let's assume they earn the same throughout their working life, until age 65.

Considering the income tax corresponding to their earnings:

• Bracket 1: Income below €12,450 pays 19%.
• Bracket 2: Income above €12,450 and below €20,199 pays 24%.
• Bracket 3: Income above €20,200 and below €35,199 pays 30%.
• Bracket 4: Income above €35,200 and below €59,999 pays 37%.
• Bracket 5: Income above €60,000 and below €299,999 pays 45%.
• Bracket 6: Income above €300,000 pays 47%.

The portion Juan decides to invest comes from his net salary, from which income tax has already been withheld. However, Noé contributes directly to his employment pension plan from his gross salary and does not pay income tax on it, which at the end of the year generates an additional €186.90* in savings available thanks to income tax savings—money that, reinvested annually in the plan, is a great advantage over the years.

*€186.90 is the result of taking the highest income tax bracket this worker falls into (Bracket 3), which would be 30% on the portion exceeding €20,200, and applying the corresponding income tax rate to the €625 saved.

Let's say both investments yield the same result, +4.4% annually—the historical average of the Pension Plan we offer at Arca with lifecycle strategies (the composition between fixed income and equities depends on the saver's age). If he opts for investment funds, investing €625 at the end of each year with an average annual return of +4.4%, he will have €76,274.60 at age 65.

However, opting for the Employment Pension Plan allows saving €186.90 annually, which reinvested along with the €625/year generates an amount reaching €99,083.80 at age 65. That's 29% more!

5. Withdrawal Strategies

With either product, it's possible to optimize taxes on savings when you withdraw them. The most suitable strategy upon retirement is to plan the withdrawal so as to minimize taxes paid—for example, selling shares in batches in the case of funds, or with a life annuity in the case of a pension plan. However, it will depend on the saver's conditions at the time. It is therefore crucial to have a well-defined exit strategy and avoid the common mistakes most people make when they retire.

At Arca, our goal is for savings—the result of our clients' work and effort—to remain in their hands to the greatest extent possible. That's why we offer smart pension plans that provide continuous support to our clients, even at the time of withdrawal. For example, by withdrawing capital gradually, not only are taxes reduced, but the money not withdrawn continues generating returns, thus increasing the available capital in the pension plan.

6. In Summary

Pension Plans allow you to defer tax payments until withdrawal, providing potentially greater immediate savings, and are designed for long-term investments—especially beneficial during periods of low income such as retirement.

On the other hand, Investment Funds offer greater flexibility and can be used for different financial goals, but taxes are paid both on the initial income and on gains at the time of withdrawal.

At Arca, we are firm advocates of (Employment) Pension Plans as they offer the best advantages for the average saver who does not have deep knowledge of financial instruments. The good news is that they are not mutually exclusive. You can always allocate part of your savings to one and part to the other, and discover through practice which one you feel more comfortable with.