How does a pension plan work?

We'll tell you all the details you need to know about pension plans
A pension plan is a long-term welfare savings product, the main objective of which is to generate savings that will be available on retirement as a capital sum or regular income. These plans operate based upon the regular or occasional contributions made by the account holder, with this money then being invested by the plan's managers according to certain criteria for returns and risks, as established in advance in the investment plan's policy. This means that when the account holder redeems the pension plan, the money he or she will receive includes the total amount contributed over the years as well as any returns the account has been able to generate. Let's take a more detailed look at how a pension plan works.
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Pension plans are based on the contributions made by the customer. These can be either periodic or occasional. There is no obligation to make contributions, and they can be stopped and restarted at any time. The maximum yearly amount for contribution is set at €8,000.

In addition, those persons whose spouse does not receive an income from work and/or whose economic activities are less than €8,000 a year, may contribute a maximum of €2,500 annually to the spouse's plan.

Additionally, for persons with a recognized physical or mental disability of 65% or more, the yearly maximum limit for contributions increases to €24,250, including contributions made in their favor by third parties, which cannot exceed €10,000 a year.

Tax deductions for contributions

The amounts contributed each year to a pension plan can result in savings on personal income tax (IRPF in Spanish), by reducing the base amount subject to taxation. This can provide significant tax savings, which will depend upon the rate at which the contributor is taxed. For example, if they pay personal income tax at a rate of 24% and a total of €3,000 per year is paid into the pension plan, the tax saving would be €720.

The maximum yearly deduction will be the lesser of the following amounts: €8,000 or 30% of net income from work and economic activities. If the deduction limit is exceeded, the excess amount can be transferred to the personal income tax statement for the next five tax years.

However, when the pension plan is redeemed the money obtained will be taxed as earned income, regardless of the contingency that has generated the right to redeem. This means that if redemption occurs by the death of the account holder, the amounts received by the beneficiaries or heirs will be taxed as earned income, never as Tax on Inheritance and Gifts.

What does a pension plan invest in

As the customer continues to make contributions into his or her pension plan, the plan's managers are performing a series of investments in order to obtain the highest returns. The nature of these investments will depend upon the type of plan that has been contracted. In terms of the investments being made, the most common types of plans are:

  • Fixed-income plans (short-term to long-term, fixed-income government or corporate bonds).
  • Equities plans.
  • Mixed plans, with different proportions invested in fixed-income and equities.
  • Guaranteed plans.

One type of plan or another may be recommended depending upon the investment profile to be adopted: conservative, moderate, or resolute. Fixed-income plans represent a product with less theoretical risk, and therefore lower returns, while equities pension plans carry more theoretical risk but also offer higher potential returns.

As time passes it is important for savers to continue adapting the risk profile for the plans they possess, in order to avoid additional risks (from being in a plan with more risk than appropriate), or to avoid opportunity costs in relation to returns (from being in a plan with less risk than could be tolerated). For those who do not want to worry about such transitions there are life-cycle pension plans, where the account holder chooses a plan that will mature close to his or her retirement date, and with the plan's managers being responsible at all times for adapting the risk profile.

Redeeming a pension plan

Once retirement occurs (whether at the ordinary age, or early or deferred), the customer will be able to redeem his or her pension plan, or in other words, be paid back the contributions made over the life of the plan, plus any returns these contributions may have generated.

In addition to retirement, there are other contingencies and exceptional financial circumstances that can allow for early redemption of a pension plan.

  • Long-term unemployment: the account holder for the pension plan will have to verify three requirements:
    • Being in a legal situation of unemployment.
    • Being registered as a job-seeker.
    • Having exhausted the contributor's benefit for unemployment or not having the right to it. 

If self-employed, the account holder must have exhausted the right to receive unemployment benefits and must be registered as a job-seeker.

  • Permanent inability to work: This can be full, absolute, or severe disability.
  • Severe dependency or high dependency: the account holder must verify the severe dependency or high dependency.
  • Serious illness: the account holder must verify the condition of serious illness. This situation also includes those where the serious illness is suffered by a spouse or by a first-degree ancestor or descendant.
  • Death: in the event of the account holder's death, his or her beneficiaries will be the ones to receive the capital accumulated in the pension plan. If no beneficiaries are designated, then the account holder's own heirs will be the ones to receive the money.
  • Foreclosure: until May 2017, the capital accumulated in a pension plan can be redeemed to make mortgage loan payments if the account holder is involved in a mortgage foreclosure process. There are two requirements in relation to this: that the mortgage payments cannot be made in any other way, and that the capital redeemed is sufficient to prevent the foreclosure.
  • After a ten-year period: Beginning on January 1, 2025 it will be possible to redeem any pension plan shares that have been held for a minimum of 10 years.
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Sustainability of the system

When a customer decides to redeem his or her pension plan, there are various options for receiving the money.

  • Redemption as a single payment (lump sum): all of the money accumulated in the pension plan is received all at once. This means that all of the taxes associated with redeeming the plan must be paid at the same time, which tends to generate a higher taxation impact.
  • Redemption as periodic income: A specific amount of money is received in the form of periodic payments, which will depend upon the amount of time agreed upon for redeeming the plan and the type of income selected. There are two possible options:
    • Assured income: the same amount is always received, either for a specific time period or for life.
    • Financial income: The amount received will depend upon the returns from the investments made by the pension plan's managers, and these payments will continue as long as a balance remains in the pension plan.
  • Mixed redemption: an initial payment for a stipulated amount is received, then afterwards a periodic income, which may be assured or financial.

That is how a pension plan works, which is an important savings and investment option for anyone who wants to supplement their public retirement pension.

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