Private Pension Plan in Germany: Overview & Best Options

What is a Private/Individual Pension Plan?

Individual pension plans, also known as private pension plans, are very flexible pension products, and insurance companies are offering plenty of products on the market. The basic function is easy: You pay in a part of your income every month or every year so that when you retire you get a pension in addition to the statutory pension. Your contributions are then invested until you seek to be paid out. That’s where it comes to the crucial differences between the various insurances offered: the way that they invest your contributions.

A private/individual pension plan also allows you to choose how you would like your pension to be paid out during retirement, notably as a lump sum or as an annuity. Most of the time, you don’t have to decide on this when closing the contract, but you can decide on this at a later stage.

Normally, upon your death, the built-up capital, including return, is paid out. The sum paid to the beneficiaries in case of your death is capital gains tax-free. The annuity option is not permanently inheritable, but in many cases, there is an annuity guarantee period (known as 'Rentengarantiezeit' in German) of usually 10 years. If you take out the annuity and die shortly afterward, your pension will be paid out to your heir until the end of the guarantee period.

Additional options

With many private/individual pension plans, you have the option to include disability insurance, a survivor's pension, or additional accident insurance.

You can also elect to insure against conditions in which it is hard to pay your contributions, for example, if you become unemployed or destitute. However, experience shows that it is usually cheaper to take out this additional insurance coverage separately. In addition, you will still have flexibility if you have liquidity problems. After all, if you reduce your pension payment for a short time, this has no effect on the supplementary insurance cover.

Optimal choices to structure your private/individual pension plan

We would recommend against choosing the annuity option in the vast majority of cases. The reason is that these annuities are now invested in low-return bonds and attract a lot of costs. Only if you expect to grow over 100 years old does it really pay. So only if you cannot afford to take any investment risk, or if other alternatives like an investment property are not available, does it make sense to purchase an annuity upon retirement.

Choosing the lump-sum option avoids the implicit cost of the annuity, is flexible, and always allows you later in life to buy an annuity. With Pensionfriend's Private Pension Plan, you can take out these lump sums every year (and more). This allows your lump sum to continue to be invested.

You can always decide to use part of your assets to purchase an annuity. This can be beneficial later in life when you do not want to be bothered with too much investment risk and have some more certainty. The annuity is much more beneficial at that time, as you have benefitted much longer from a high investment return and low cost. Moreover, the tax rate on the annuity declines with age. Besides, if interest rates happen to be much higher, annuities may become more attractive again. See more on this below.

The bottom line: you do not have to choose now. But do pick a plan that allows you the flexibility to keep investing at low cost and take the lump sum out frequently and again at low cost.

Three different types of private pension plans in Germany, but only one real option

When you are looking to secure your standard of living in old age with private pension insurance, you should pay close attention to which form of private pension plan you choose.

1. First, there is the ‘classic model’ of private pension plans. With this model, you get a 100 % guarantee on your paid-in contributions. However, it is also tied to the guaranteed interest rate of currently only 0,25 %. The guarantee implies that the classic private pension insurance is very conservatively invested in bonds with low or negative yields. As costs are deducted from the guaranteed return, your net return is most likely actually quite negative.
   
   For example, if your investment return is equal to the guaranteed 0,25 % and your cost is 2 % annually (this is a pretty common cost level), then the guaranteed product loses you 1,75 % per year!
   

2. There is now an approach to solving the problem of classic private pension insurance via partial guarantees. With this 'new classic model', you can choose the level of the guarantee, and then when there is outperformance this money is better invested.
   
   In essence, this is the old wine in new bottles. It is no better than the classical model. It is a way for insurance companies to avoid having to advertise the low minimum guaranteed return. As long as bond rates are low or negative, the guaranteed money is de facto, returning basically 0, while they still attract high fees, so in the end, you get a significantly negative return. You are better off putting any “guaranteed” part of your investment in a bank account or repaying your mortgage.
   

3. Therefore, we advise you to choose a third form of private pension insurance: an ETF-based private pension insurance. With this form of pension insurance, you no longer have any guarantees, but you do have the opportunity to benefit from the developments of a broad stock market.
   
   The great thing about ETFs is that they are safer than government bonds in the long term by protecting against inflation and generating higher returns as stocks keep up with the economy (including inflation and real growth).

Fees for private pension plans

We have already stated that we absolutely do not recommend the ‘classic’ model of private pension insurance or the ‘new classic’ model — also because of the sometimes very high fees. That's why we only want to discuss the fees of the ETF-based private pension model we recommend here.

To assess the overall costs, each contract comes with an effective cost number (called 'Effektivkosten' in German), which indicates how much the aforementioned fees reduce the annual return. For example, if the funds in your contract are targeted to achieve a gross return of 6 % and your contract has 2 % effective costs, you will have a net return of 4 %. It can be used to compare different contracts since it represents the impact of all fees on return. It is common to find the effective costs in the range of 1,4-2 %, but we have seen amounts as high as 3,5 % and as low as 1 %.

And while the difference between 1 % and 1,4 % may not sound all that much, it can certainly make a significant difference over the long run!

The effective costs, in turn, are composed of several elements, including upfront fees, fees on the amount paid in, annual fees on the capital build-up, and monthly fixed charges. In particular, the upfront fees can be quite damaging. Many companies charge up to 2,5 % of the total insurance sum that you, e.g., commit to contributing over 30 years upfront. It means that it takes a lot longer for your capital to build up and start earning returns and that if you decide to stop contributing, you have costs that are much higher than the predicted effective costs. Also, if performance disappoints you actually pay relatively more than what you were told the effective costs would be, as they are based on the return assumptions. We therefore strongly advise finding providers that charge mainly or only based on the actual assets.

Tip: While most insurance companies consider the highest, others consider the lowest cost fund, which can make a massive difference, thus when comparing effective cost you have to be very careful. In the contract, the providers also specify the maximum cost of canceling the pension, or changing the contract called 'Kündigung wegen Vertragswechsel' and 'Kündigung mit Auszahlung'.

Tip: We have seen really high penalties for canceling contracts, like forfeiting all returns. Do review these clauses closely, and consider stopping additional contributions instead of canceling. For the phase of retirement, there is also a one-off administrative fee of usually 1,75 % for the payout.

As you can see, fees can significantly cut your returns. Be aware that, typically, insurance brokers get paid more for expensive products. So it's worth taking a close look when choosing your private pension insurance. At Hypofriend, we have created our own effective cost calculator so we can check the cost of different products, and we have preselected the cheapest providers.

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Tax benefits and penalties with a private pension insurance

In the pay-in phase, there are no tax benefits with your private pension insurance, so you can’t deduct your contributions from your tax bill. There are some potential tax benefits for private pension products, but only in the pay-out phase. The tax then depends on the payment option.

Annuities are subject to income tax but in a rather complex way

If your pension is paid out as an annuity, then only a portion of your monthly pension is taxable. Keep in mind, though, that the tax is levied not just on your gains but also on your contributions.

The taxable portion of the pension depends on when your annuity (known as 'Leibrente' in German) commences. For each age, there is a different corresponding percentage of pension that can be taxed. Generally, the older you are, the lower the tax rate.

Only the so-called 'Ertragsanteil' is taxable. For example, if you retire at 62, only 21 % of your pension is taxable. Therefore, if you receive a monthly pension of 1000 € and your personal income tax rate is 30%, you have to pay 30 % × 21 % × 1000 € = 63 € per month of income tax or about 6 % on your total gross pension. The share of pension income that is taxed ('Ertragsanteil') remains constant for the duration of the whole pay-out phase.

See the second table on this page for the rates for all ages from 50 to 100 and the corresponding amount taxed.

Note: You pay the calculated 6% tax rate in the above example over the entire sum and not just on what your investment has gained! So if your return on your private pension insurance is poor, the tax rate is actually rather high, and vice versa. So, from a tax perspective, investing in low-return products (such as those with guaranteed returns) and then getting an annuity is a bad idea. For example:

With an investment of 200 €, capital gains of 800 € and a tax of 63 €, your gains are taxed at a rate of 63 €/800 € = 8 %

On the other hand, an investment of 900 €, capital gains of only 100 € and a tax of 63 € means your gains are taxed at a rate of 63 €/100 € = 63%

As the 'Ertragsanteil' depends solely on the age at which you start to pay out, it is beneficial, from a tax perspective, to start the private pension plan early if you choose an annuity: it means you have a long period to build up a high return. It also implies that you should only choose the lump sum version if the run time is short.

The lump sum payment is subject to a reduced capital gains tax: the beauty of the tax shield

The lump sum version of the private pension insurance is only subject to taxation once: when you take your money out.

If you hold private pension insurance for over 12 years and take the whole sum out in one go after the age of 62, only half of the return on your investments is subject to taxation.

If you invest directly in ETFs yourself, you would have to pay 26,375 % capital gains tax on the profit of every sale, which tax is withheld by your broker. 

Even if you switch the ETFs to rebalance your portfolio, you pay taxes. That's why you will get more return in the long run with a low-cost ETF-based private pension insurance than if you buy ETFs yourself:

To optimize your taxes, you will typically want to conclude several private pension plans and have them pay out at different times. In the flexible private pension insurance that we offer, you can then add over time amounts to the different private pension plans without incurring additional costs.

Discover Pensionfriend's Pension Plan, the smart and tax-efficient solution for your retirement

Immediate pension with a one-time payment

You can also use individual pension insurance to obtain an immediate pension. With this option, you pay in a lump sum and receive then, in return, an immediate annuity — for the rest of your life. You also have the option to choose if you would like a fixed higher pension in one phase of your pension and lower in another (called 'dynamic annuity'). 

This option can be considered if you are close to retirement and have a larger amount of money at your fingertips, for example, from selling a property, an inheritance, or a life insurance payout.

With current interest rates and the way insurance companies calculate life expectancies, the annuity is relatively unattractive. For a payment of 100.000 €, for example, you can expect a gross monthly pension of around 330 € from the age of 67. So you would have to get pretty old and draw the pension for more than 22 years to get your money back. 

In principle, you are better off buying your home or contributing as much as possible to the public pension. Also, working an additional year to create more of a buffer and then investing this money gainfully in ETFs would result in a much higher buffer later in life. But if you don't have those options and want to make sure you have a minimum guaranteed income throughout the rest of your life, then this is the option to choose.

Note: Life insurance vs. private pension plan 

Capital life insurance (known as 'Kapitalebensversicherung' in German) has, in practice, the same options as private pension plans, which is why we just refer to the latter. For example, both products can be chosen with lump-sum payouts and life insurance options. It is about deciding what options to use and not about the name.