Tax return on a buyout

Is redemption in the provident fund a good investment ?

"Given the poor return applied to my pension assets, I am certainly not going to make any redemptions! "  

This reaction is observed among many affiliates when they examine their pension certificate and believe that the return offered by their fund is really not high.

And they are not wrong! If we are to believe the CS index of Swiss provident institutions, the average annual return of Swiss pension funds stands at 3.41% from January 1, 2000 to June 30, 2021.

And this figure does not correspond to what policyholders receive, since it is the Foundation Board of each fund which decides the return which will be allocated to affiliates, subject to the minimum set annually by the Federal Council for the compulsory part and several other rules, including the coverage of value fluctuation reserves.

This is how the annualized minimum LPP remuneration stands at 2.13% for the period under review. For 2021 the minimum has been announced at 1% and it is a safe bet that the Foundation Boards will maintain a prudent remuneration policy, in particular because of the trauma caused by the violent stock market corrections of 2001 (burst of the TMT bubble), 2008 (credit crisis and Lehman affair) and 2020 (Covid crisis) and the ridiculously low level of bond yields in Switzerland.

Based on this observation, we easily understand policyholders who prefer to keep their savings and invest them in more attractive investment vehicles, with the added bonus of the freedom to dispose of their assets at all times.

However, a simple comparison of returns would be incomplete and biased, since it excludes the tax dimension. However, the latter is decisive, in particular for socio-economic groups with comfortable incomes, the majority of whom are those who make investments on the stock market and ask themselves the question of making redemptions in their pension plan.

Taxation on income and wealth is essentially a cantonal responsibility. There are therefore as many tax practices as there are cantons. For our demonstration, we will retain the case of the canton of Geneva, whose tax burden is high for high income brackets and the wealth tax is one of the most expensive in Switzerland.

Let's imagine a married couple, both spouses occupying executive positions and generating taxable income of around CHF 300,000.- per year, i.e. a marginal tax rate of around 45%. The couple's wealth is also comfortable and therefore their tax rate is around 0.9%.

A pension buyout of CHF 100,000.- (for example) will therefore have the following tax consequences:

• Immediate saving of CHF 45,000.- in income taxes.
• Savings of 0.9% each year on the value of capital invested (i.e. CHF 900.- for the first year).
• Savings of 45% each year on capital income invested in pension provision. If we estimate the latter at 1.5% the saving is 0.68% per year, or CHF 680.- the first year).
• We will keep in mind that if the couple wishes to recover their “redeemed” years in capital upon retirement, the taxation of these pension assets in Geneva will be around 8.6% (single and separate taxation of other income, relatively low compared to the Swiss average).

We then see that transferring part of your “free” savings to your pension foundation offers several tax advantages, both at the time of redemption and throughout the period of ownership in the pension fund.

To simplify, we can break down the tax advantage between an annual saving of 1.58% (0.9% + 0.68%) and a one-off saving of 45% at the time the buyout is made. This is a sort of reverse capital gain, corresponding to the tax savings on income saved in the form of redemption in the pension envelope.

The impact in terms of return of this second component will of course depend on the period of holding the amount repurchased in the provident fund. We know that the latter must be more than three years for the tax authorities to accept the deduction at the time of redemption.

From then on we can calculate the “tax return” of a pension buyout based on the number of years of ownership. This interest rate is an opportunity cost: it corresponds to the additional return that an individual who prefers “free” savings to redemption will have to obtain, to compensate for the tax impact of their decision.

The most important lessons from this table are:

1. Unsurprisingly, the tax return on a buyout in the pension envelope decreases with the increase in the holding period. In other words, it is better to carry out buyouts as late as possible in your professional life, while keeping in mind that the rule of a minimum holding of 3 years for the deductibility of the buyout applies to the date effective retirement, which is not always plannable or known in advance.
2. The relationship between our two parameters is not linear and will tend towards the level of 2.6%.
3. Tax efficiency is very important for periods of less than 15 years. The annualized rates are above 5%, a return that is today impossible to achieve without taking greater risks than that of your pension fund.

In this letter we have only addressed the tax dimension. It will be remembered that pension buyback strategies depend on multiple other factors, such as for example the need to make up for a pension deficit to ensure one's old age, the availability of cash to carry out buybacks or even the use of buybacks in instead of partial repayment of a mortgage.

The Impact Financial Engineering team is of course at your disposal to place this approach in your overall heritage context and to calculate this opportunity cost for other cantons.