Lump sum or annuity? The right strategy for withdrawing pension fund assets
Pension fund assets often represent the largest part of a person's assets at the end of their working life. It is therefore important to consider whether to withdraw them at retirement as a lump sum or in the form of a pension. We look at the importance of the conversion rate and region.
The conversion rate determines the amount of the annuity or pension that is paid by the pension fund
If retirement savings are drawn from the second pillar in the form of a pension, the amount of the pension is calculated using the conversion rate. Given a conversion rate of 6.0%, the annual pension equals 6.0% of the accrued retirement capital. So, if the retirement capital amounts to CHF 100,000, for example, the pension would be CHF 6,000 per year.
In view of the reality of low interest rates and progressive demographic aging, pension funds have gradually reduced conversion rates in the extra-mandatory segment in recent years. According to the Credit Suisse pension fund survey, pension funds expect an average conversion rate of 5.5% for the period 2017 to 2022. The correct conversion rate in actuarial terms would be somewhere around 5.0%: The trend toward declining conversion rates is likely to continue.
Properly planning the lump-sum withdrawal from the pension fund
With a lump-sum withdrawal, on the other hand, the money is transferred from the pension fund to the individual's private assets. The individual has free use of the capital withdrawn. However, the assets are intended to last for the entire retirement duration. That makes it important to calculate how much capital can be used, and in what timeframe.
The longer the period that the capital has to cover, the lower the amount that should be spent each year. How much this is also depends on the return that can be achieved on the withdrawn capital. This varies depending on the risk tolerance and chosen investment strategy. Higher returns typically involve higher risks.
The tax burden for withdrawals varies from one region to another
Finally, fiscal aspects play a role, because pensions – whether from employee benefits insurance or the state pension scheme (AHV) – are fully taxed as income. Tax must also be paid on lump-sum withdrawals, though separately from the rest of your income and at a reduced rate. The tax burden can be reduced significantly in the case of a complete lump-sum withdrawal from the pension fund. The wealth tax is higher but is usually more than offset by the reduction in income tax.
The tax burden for lump-sum withdrawals varies sharply from canton to canton. The differences from one municipality to another can amount to several thousand francs. For example, in fiscally attractive Wollerau (Schwyz), a withdrawal of CHF 100,000 would be subject to CHF 1,938 in taxes, but in Herisau (Appenzell Ausserrhoden) this would be nearly four times as much at CHF 7,875.
Withdraw a lump sum – yes or no?
Taking the key factors described such as conversion rate and tax burden into consideration, an overall financial analysis can be carried out. How does the choice between lump sum and annuity affect the assets that are available during retirement?
To answer this question, Credit Suisse has calculated net income after taxes for all municipalities in Switzerland under a variety of scenarios. Scenarios were calculated for a range of retirement assets taking account of the burden from lump-sum, income and wealth taxes that varies from one municipality to another. Thus in the city of Zurich, a full annuity – for example at a conversion rate of 5.0%, a pension duration of 25 years, and an expected return of 2% – is as attractive in financial terms as a full lump-sum withdrawal (see chart). At a lower conversion rate, shorter pension duration or higher return on the withdrawn capital, the lump-sum withdrawal is more attractive than the annuity. In regions with a higher tax burden, the lump-sum withdrawal becomes more attractive at an earlier stage.
Pension fund capital subject to many influences
Due to the regional differences in the tax burden, the amount of income available during retirement hinges to a significant extent on place of residence. The same withdrawal strategy can result in a difference in annual net income of up to almost 12,000 Swiss francs, depending on the place of residence.
It is worth considering each specific case in detail. Family situation, inheritance aspects, health, and living standards must also be taken into account.