Low, lower, German state pension

Before you read on, I should start with a disclaimer: this one is a bit hard-core. Reading it might feel like you accidentally ordered a cocktail which has 2 parts complexity, one part pessimism and a sprinkle of what-the-fuck on top. And then you realized you didn't order just one, but a whole bucket. Read on at your own risk.

With that being said, let's go.

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I often write and talk about all the different ways in which the German state pension system is broken. I think by now it's already a consensus and it's not like I really need to convince anyone of that. But I also wanted to see just how bad is it really?

In presentations and workshops I gave I presented examples of how big the "pension gap" might be for an average person (that is, the gap between what your future pension will provide and what you actually need). I even went further to show that it doesn't matter how well you earn, it won't save you (in fact, high-earners are actually worse off, but that's for another time).

But I still wanted something more concrete. When we say "bad", what does it mean?

One aspect that is often neglected is just how much the average person will contribute into the system over their entire career. The answer is A LOT:

9.3% of your gross salary is deducted for this purpose, and your employer adds their part as well, which is ANOTHER 9.3%. So 18.6% of your gross salary. If you're making €5,000/month gross, that's €930/month, or €11,160 annually.

And this got me thinking: As we all unfortunately know, this money is not invested. I'd love to say it's just sitting somewhere but that's not even the case, because it doesn't have time to seat anywhere: the second it comes in, it has to be rushed out to pay somebody else's allowance, and it's not even enough for that. But what if this money was invested? if we imagine a parallel universe in which our contributions are invested, what is the average annual return this investment would need to have, in order to generate the same monthly allowance? or more realistically, how low must it be, to be equal to the state pension?

Comparing apples and...?

This is where complexity comes in; we're not comparing apples to apples here. The pension system is a point-based system; you accumulate points based on your total salary, and the value of each point is adjusted every year. Based on the number of points you've accumulated, your allowance will be calculated:

The total amount contributed by you and your employer is not ear-tagged for you and is not under your name. There's also no clear formula that says that if you have accumulated amount X you'll get a monthly allowance of Y. While it's clear how points are accumulated, it's entirely unclear how much each point is going to be worth. It's a political/financial decision. In my calculation, I assumed the value of each point is adjusted by 2% per year (from its current value today), which closely reflects the recent history in Germany.

On the other hand, with our imaginary portfolio, things are at least clearer: we invest the same amounts that were otherwise contributed into the pension system, in the exact same way (monthly deposits of 18.6% of our gross salary). What we get is a portfolio that grows at a certain pace (i.e., it's average annual return + the regular deposits), but it's still not comparable to the pension system.

To make this comparison, we need to make some assumptions:

Allowance vs. Withdrawals

How much can be withdrawn from our portfolio on a regular basis, while guaranteeing that it won't be depleted while we're still alive? A good starting point would be the 4% rule. In essence, it says you withdraw 4% of your total portfolio value in the first year of retirement, and then adjust it annually according to inflation, to maintain your purchasing power.

While it's a good starting point, there's critique going in both directions, mentioning 4% is either too high or too low. So in my calculations I looked at range, from 3% to 5% in 0.5% increments.

Different people, different careers

Another issue of course is, how many points were accumulated? This depends on the career path of our imaginary saver. They might earn close to the average, much more or much less. Their career might also progress at different speeds, increasing their salary (and with it, their contributions into the system) in different ways.

To handle this, I've looked at 4 different scenarios:

• Low earner

• Conservative

• High-earner

• Maximum contributions

Net vs. Gross

Pension allowance is not tax free. There's income tax and social contributions to be paid. With withdrawals from a stocks/ETFs portfolio, there's capital gains tax to pay. To simplify the calculations, I compared the gross amounts in both cases. To be clear, this is actually cutting the pension system some slack. Pension allowance is taxed same as any other income, and income tax is progressive. Capital gains tax on the other hand is a flat-rate tax.

If you have a high pension allowance you'll pay more taxes, potentially higher than the capital gains tax rate. However, if your overall income puts you at a lower tax rate than the capital gains tax rate, you'll actually pay less (see "Günstigerprüfung"). So if anything, capital gains tax has an advantage over normal income tax. But again, I wanted to keep it simple.

To put it all together, we assume we deposit the same amounts we would otherwise contribute to the pension system. These deposits go into a portfolio, and we're looking to find the annual average return of this portfolio, which would yield the same monthly (gross) cashflows as the state pension system.

The results are in

Let's see what we get. As mentioned, I have calculated 4 different income scenarios and 5 different withdrawals rate, so a total of 20 scenarios. Here's what it looks like:

Average annual return providing the same gross monthly amount as state pension under various salary scenarios and various withdrawal rates

Salary Scenario/SWR	3.0%	3.5%	4.0%	4.5%	5.0%
Low-earner	3.2434%	2.4383%	1.7146%	1.0530%	0.4405%
Conservative	3.2630%	2.3925%	1.6055%	0.8843%	0.2143%
High-earner	3.2752%	2.3619%	1.5323%	0.7667%	0.0516%
Maximum	3.2411%	2.4420%	1.7189%	1.0537%	0.4341%

What does all of that mean?

It means that contributions into the state pension system are equivalent to a really, really un-attractive investment. In most scenarios in the table above, even with a 2% annual adjustment to the pension points value, it's not even enough to completely offset inflation (values in red are below 2%, which is a good, if not optimistic, long-term estimate for inflation). It's an investment that, in real terms, is losing money.

It's clear to see how, the more cautious you are with your withdrawal rates, the higher the return that is required to match the pension system allowance. But at a 3% withdrawal rate, it's very very likely that your portfolio will increase significantly during your retirement years and that your children will inherit millions as a result. In other words, you'll be withdrawing too little, not living like you could, and even then - it would mean you've invested in something that gave you around 1.2% above inflation. Mind you, Bill Bengen, the person widely regarded as the "creator" of the 4% rule, now actually believes 4% is too low, and 4.7%, potentially 5%, would make more sense. This would mean the number in the 5% column are the relevant ones. And they're just terrible.

The really unfortunate part is that there's nothing much you can do about it. Contributions are mandatory, they're being deducted automatically from your salary and that's just the way it is. If there's any takeaway from this, it's this: even if you knew before that the state pension system is not great, you might have thought "well ok, but at least it's there, it can serve as a base layer, and if I just do a little bit of extra on my own I'll be fine".

Would you feel the same way if the state told you you have to invest into a product that gives negative real returns? probably not. But that's exactly the case. If you're an employee and you're counting on this system, even just partially, you need to wake the f^&$ up.

If you've made it all the way here, respect. This was both technical and depressing. Sorry for that.

I'm really fun at parties, though :)