Fear of poverty in old age – Which pension system is the safest?

More than half of all millennials fear poverty in old age. It ranks high in terms of fears for the future; only the fear of terrorism is greater. Scepticism about the performance of the statutory pension is a major factor. Still, only 45.8 % of Gen Y is already saving for retirement.

The continuous reduction in pension levels in recent years makes millennials doubt the security of statutory pensions. Demographic change means that this negative trend is unlikely to stop. Many people are therefore advocating a fundamental reform of the pension system. In Germany this would mean a change from a pay-as-you-go system to a so-called funded system. But would that make any sense?   

Only different at first glance

When the two pension systems are compared they seem, initially, to be completely different. In the pay-as-you-go system, contributions paid in by current employees are passed on directly to pensioners. If the economy grows, and salaries with it, this is reflected in an increase in pension levels. Germany and the rest of Europe are, however, now facing a problem, as the birth rate is steadily dropping meaning fewer replacement employees. This results in a drop in the sum of contributions, and thereby, a slow decrease in pension levels.

In contrast to the pay-as-you-go system, in the funded system each generation does not pay for the next, rather each one saves for itself. While working, employees invest in financial investments, funds, or private life and pension insurances. When they retire, the accumulated assets are then slowly dissolved to finance the retirement. But in this model, retirees are still dependent on current employees. After all, someone has to buy the capital investments. If there are fewer employees, high supply meets low demand and retirees get less for their investments than they had hoped.

In both cases, therefore, current employees finance the retirement of current retirees. The funded system does, admittedly, allow investments to be made in countries in which the number of employees is (currently) very high, limiting demographics related losses. However, many industrialised countries are facing the same problems and investments in developing and emerging economies are connected with greater uncertainty. Investments in foreign currency are also always exposed to the risk of unfavourable currency developments. A general rule for any funded scheme is: there are always investment risks.

What does that mean for retirement planning?

No matter how you look at it: monthly pension payments will decrease as a result of demographic change. It is difficult to determine which pension system is more reliable. Both have their benefits and drawbacks. So what now? The key phrase here is risk distribution. When it comes to retirement planning, it's best not to put all your eggs in one basket – whether pay-as-you-go or funded. It is a great idea to supplement state pension insurance with a funded private or company pension scheme. It may be equally worth it for the self-employed and freelancers to pay voluntary contributions to the state pension fund. Talk to your OVB financial consultant to find the best retirement strategy for you.