Planning for retirement is a common concern among all working people; it is a crucial consideration for life after work. During election season, all eyes will be on pension reform and how it is addressed in campaign platforms and debates.
So let's try to understand this model better.
The French Model
In France, the pension system is based on a pay-as-you-go system, in which contributions from working people are used to pay the pensions of current retirees.
However, this pay-as-you-go system has some major drawbacks:
- The money is managed by the government: The funds are used to pay current retirees, with no guarantee as to when people will actually retire in the future.
- Income Decline: There is generally a 20% loss in income when transitioning from working to retirement.
- Loss in the Event of Premature Death: If you die before you have a chance to enjoy your retirement, the money is “lost” and does not benefit your loved ones.
Let’s take the example of a worker earning the current minimum wage. Each month, he contributes €493 toward his retirement. Over a 42-year career, that amounts to a total of €248,472 in contributions, resulting in a net monthly pension of €1,104. This means that over 42 years, this worker will have contributed €248,472 to receive a net monthly pension of €1,104—a replacement rate of 80%.
The Alternative
Now let’s imagine a retirement plan in which money is contributed monthly at an annual rate of return of 3 percent. Although this rate is low, it serves to illustrate the power of compound interest.
Here's what that would look like for the first year:
Year 1
Amount Invested
Cumulative Amount
Yield: 3% per year
January
493 €
493 €
1,23 €
February
493 €
986 €
2,47 €
.
.
.
.
.
.
.
.
.
.
.
.
November
493 €
5423 €
13,56 €
December
493 €
5916 €
14,79 €
To achieve this at the end of one’s career, after 42 years of service:
Year 42
Amount Invested
Cumulative Amount
Yield: 3% per year
January
493 €
473 110,01 €
1182,78 €
February
493 €
473 603,01 €
1184,01 €
.
.
.
.
.
.
.
.
.
.
.
.
November
493 €
478 040,01 €
1195,10 €
December
493 €
478 533,01 €
1196,33 €
With this system, even after withdrawing an amount equivalent to the minimum wage (€1,377 per month) for 23 years, there would still be money left in the reserve. It would even be possible to plan for a viable retirement income of €2,400 per month.
This alternative is known as a funded pension plan. Chile, Sweden, and Australia have adopted it.
A defined-contribution pension plan allows you, even if you earn the minimum wage:
- To have saved twice as much.
- To ensure a steady income for 23 years (that is, until age 88).
- In the event of premature death, the money becomes part of the estate and benefits your heirs.
And that's not all!
During your retirement, the money you’ve set aside continues to grow—even if you withdraw some of it every month. If you withdraw the amount of the minimum wage every month for 23 years, you’ll still have a little money left:
23 years of retirement
Amount Withdrawn
Cumulative Amount
Yield: 3% per year
January
1377 €
430 104,75 €
1075,26 €
February
1377 €
428 727,75 €
1071,82 €
.
.
.
.
.
.
.
.
.
.
.
.
November
1377 €
416 334,75 €
1040,84 €
December
1377 €
414 957,75 €
1037,39 €
Under these circumstances, even a pension of 2,400 euros per month would be feasible. Let’s take the example of the 23rd year of retirement again:
23 years of retirement
Amount Withdrawn
Cumulative Amount
Yield: 3% per year
January
2400 €
48 121 €
120,30 €
February
2400
45 721 €
114,30 €
.
.
.
.
.
.
.
.
.
.
.
.
November
2400 €
24 121 €
60,30 €
December
2400 €
21 721 €
54,30 €
So why not?
Why not adopt a funded pension system in this case? Because our current system is based on the principle of intergenerational solidarity: today’s workers finance current pensions in the hope that future workers will do the same for them. Implementing a funded pension system would mean either sacrificing current beneficiaries or forcing the government to bear the financial burden of pensions alone. This would result in a colossal annual deficit of 80 billion euros.
Want to have some fun simulating your defined-contribution retirement plan? Then download our Excel file: