Private Pension Saving : Save in stocks using IPS or directly on the stock exchange?

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JÖNKÖPING UNIVERSITY

P r i va t e P e n s io n S a vi n g

Save in stocks using IPS or directly on the stock exchange?

Master’s thesis within Economics

Author: Arpad Teleki

Tutors: Associate Professor Per-Olof Bjuggren Ph. D Candidate Helena Bohman

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Title: Private Pension Saving Author: Arpad Teleki

Tutor: Associate Professor Per-Olof Bjuggren Ph. D Candidate Helena Bohman Date: June 2006

Subject terms: Life-cycle hypothesis, IPS, taxes

Abstract

This thesis analyzes the differences in monetary return when saving in stocks using Individual Pension Saving (IPS) or saving directly on the stock exchange (OMX). An individual is assumed to have the same portfolio of stocks whether he or she uses IPS or OMX. Different length of saving years, payment years, real rates of return, saving amounts and different tax rates are compared to each other between the systems. The results indicate a clear benefit using IPS in the long run, when tax rates are higher during the saving period compared to when retrieving the payment. It also indicates an uncertain usefulness of IPS compared to OMX when individuals have only income tax when saving and retrieving payment. In some cases using IPS can generate a monetary loss compared to OMX. Individuals that are low-income earners and prefers a low risk in their investments should not use IPS, while high-income earners that prefer high risk investments should use IPS instead of directly investing on the OMX.

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Titel: Private Pension Saving Författare: Arpad Teleki

Handledare: Docent Per-Olof Bjuggren Doktorand Helena Bohman Datum: Juni 2006

Ämnesord Life-cycle hypothesis, IPS, taxes

Sammanfattning

Den här uppsatsen analyserar skillnaderna i avkastning om man sparar i aktier när man använder sig av Individuellt pensionssparande (IPS) eller sparar direkt på börsen (OMX). En individ antas inneha samma aktieportfölj vare sig han eller hon nyttjar IPS eller OMX. Olika längd av sparande, utbetalning, olika realavkastningar, olika sparnivåer och olika skattesatser jämförs med varandra i de olika systemen. Resultaten indikerar en klar fördel för användandet av IPS på lång sikt, när skattesatsen vid sparandet överskrider skattesatsen vid erhållandet av betalningen. Det finns också indikationer på osäkerhet vad gäller nyttan av att använda IPS jämfört med OMX när individer endast har inkomstskatt både vid sparandet och vid erhållandet av betalningen. I vissa fall kan individen förlora på att nyttja IPS jämfört med OMX. Individer som är låginkomsttagare och föredrar låg risk på sina investeringar skall ej använda sig av IPS, medan höginkomsttagare som föredrar högrisk på sina investeringar skall använda IPS istället för OMX.

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1 INTRODUCTION...5 1.1 BACKGROUND...5 1.2 PURPOSE...6 1.3 FRAME OFREFERENCE...6 1.4 METHOD...6 1.5 FORMERRESEARCH...6 1.6 OUTLINE...7 2 CONSUMPTION OR SAVING?...8

2.1 A MICROECONOMICAPPROACH...8

2.2 LIFE-CYCLE ANDPERMANENTINCOMEHYPOTHESIS... 11

2.3 UNCERTAINTY... 13

2.4 TAXES... 13

3 WHICH POSSIBILITIES OF SAVING EXIST TODAY?... 16

3.1 TRADITIONALPENSIONINSURANCE... 16

3.2 MUTUALFUNDINSURANCE(UNIT-LINKED)... 17

3.3 INDIVIDUALPENSIONSAVING(IPS) ... 17

3.4 CAPITALINSURANCE... 18

3.5 CAPITALPENSIONINSURANCE... 18

4 RESULTS AND ANALYSIS ... 20

4.1 INCOMETAX31.6%... 20

4.2 INCOME ANDSTATETAX51.6%... 21

4.3 INCOME ANDSTATETAX56.6%... 22

4.4 DURATION... 22

4.5 PAYMENTINCOMETAX31.6%... 23

4.6 PAYMENTINCOME ANDSTATETAX51.6% AND56.6%... 25

4.7 HIGH-INCOME EARNERS VERSUSLOW-INCOME EARNERS... 27

5 CONCLUSION ... 28

5.1 SUGGESTIONS FORFUTURERESEARCH... 29

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FIGURE2.1 BUDGETLINE...8

FIGURE2.2 INTERESTRATECHANGES...9

FIGURE2.3 SUBSTITUTION EFFECT... 10

FIGURE2.4 SUBSTITUTION EFFECT AND POSITIVE INCOME EFFECT... 10

FIGURE2.5 SUBSTITUTION EFFECT AND NEGATIVE INCOME EFFECT... 11

FIGURE2.6 LIFE-CYCLEMODEL... 12

FIGURE2.7 TAX EFFECT... 14

FIGURE4.1 REMAINING DURATION OF LIFE AFTER65 YEARS OF AGE... 23

TABLES

TABLE2.1 SWEDISHTAXRATES... 13

TABLE3.1 TAXDEDUCTION2006... 16

TABLE3.2 SUMMARY OF SAVING CHARACTERISTICS... 19

TABLE4.1 IPS-OMX BEFORE PAYMENT. S=19,850 SEK. T=31.6% ... 20

TABLE4.7 IPS-OMX. DURATION10 YEARS. S=2,400 SEK T1=31.6% T2=31.6% ... 23

TABLE4.11 IPS-OMX. DURATION10 YEARS. S=2400 SEK T1=56.6% T2=31.6% ... 24

TABLE4.17 IPS-OMX. DURATION10 YEARS. S=2,400 SEK T1=56.6% T2=56.6% SAVING5 YEARS.. 26

TABLE4.18 IPS-OMX. DURATION10 YEARS. S=39,700 SEK T1=56.6% T2=56.6% SAVING5 YEARS 26 TABLE4.19 LOW-INCOME EARNER. IPS-OMX. DURATION5 YEARS. SAVING10 YEARS... 27

TABLE4.20 HIGH INCOME EARNER. IPS-OMX. DURATION5 YEARS. SAVING10 YEARS... 27

APPENDICES

APPENDIX A IPS-OMX S=2400 SEK ... 30

APPENDIX B IPS-OMX S=19,850;23,030;39,700 SEK ... 30

APPENDIX C IPS-OMX; STATETAXBEFORE ANDAFTER... 30

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1 Introduction

1.1 Background

The Swedish public pension system has always been and still is a controversial question in Sweden since its introduction. How much should a pensioner receive? How much should the individuals in a society pay into a pension system? How should such a system be built to be sustainable for present and future generations? Should such a system exist at all? Should not each individual decide on their own about their retirement? These are some questions that have been raised during the last years. But how did it all start in Sweden? The first public national pension insurance was introduced in 1913 in Sweden. All men and women were included and the retirement age was set to 67 years. (Kruse, 1997)

The pension insurance system was reformed in 1935, the insurance based part weakened, while a basic pension part strengthened until 1946, when the decision to abolish the con-tributory part and only have a basic pension part was made. This implied a transformation into a pure pay-go system1_{. At the same time the pension was raised substantially. In 1959}

the pension system was changed again, by adding a supplementary pension (ATP). This was introduced to give all workers (both blue and white collar) a pension that was related to their working standard of living. In 1969 the pension contribution was introduced to give pensioners with low or zero basic pensions an additional amount of money and seven years later in 1976 the retirement age changed from 67 to 65 years. (Ståhlberg, 1995)

In 1999 a new reformed pension system was introduced, which is the system of today. It consists of income pension and premium pension. The income pension is decided by whole lifetime income (from 16 years of age). It is a defined contribution system, which means that the individual get pension benefits during life, which can be realized when go-ing into retirement. It is financed by tax, where the individual pays 16% of its income into the system. The money is transferred to pensioners the same year. The premium pension is a defined contribution system, which implies that 2.5% of the income is put into pension funds. The individuals can freely choose where to invest the money among a huge number of available funds. Depending on the development of the funds chosen, implies different amount of money to retrieve as a pensioner. (Nilsson, 1998)

As an addition to this one may also receive occupational pension, which is paid by the ployer. It is an amount between 3.5-4.5% of the salary, which is invested in funds. The em-ployee can choose to invest the money between different funds. Putting all these three pen-sion systems together, predictions shows that the amount a penpen-sioner will receive at re-tirement will be somewhere between 50-70% of the final salary before rere-tirement. Blue col-lar workers are expected to receive less than white colcol-lar workers. (Normann, 2003)

Therefore one problem for future pensioners is the gap between pensions and salaries when going into retirement. How can they maintain the same income as they had when working as a pensioner? What are the existing options today? Is it profitable to save money privately for retirement? This thesis is dedicated to people who want to save money pri-vately for retirement.

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1.2 Purpose

The purpose of this thesis is to compare whether individuals are better of saving in stocks for retirement using individual pension saving (IPS) or by investing directly on the Swedish stock exchange.

1.3 Frame of Reference

This thesis will not consider individuals living abroad or self-employed, it will only consider employed individuals in Sweden. Furthermore it focuses on financial investments, where the definition of financial investments is total savings minus real savings, where real savings are investments in real capital i.e. real estate, machines and structures (Gavelin and Sjöberg, 2006).

1.4 Method

This thesis is focusing on existing Swedish private saving possibilities for retirement regu-lated by the government and especially the IPS system. The reason why this thesis concen-trates on IPS is because it has the widest variety of saving products among the existing pri-vate pension systems. In this thesis individuals are expected to invest in stocks either in IPS or directly on the stock exchange. The portfolios are assumed to contain the same stocks, whether investing in IPS or on the stock exchange and therefore have the same return. The return in this case is assumed to be the real rate of return (return after inflation ad-justment). The reason for this is to be able to observe the purchasing power when receiving the payments. The evaluated real returns are 2,4,6,8,10 and 12 percent. Individuals are as-sumed to save between 2,400 and 39,700 Swedish crowns each year. According to Sweden Statistics the average amount for pension saving was 6,200 SEK in 20042_{. The length of}

saving years are set from one to forty years, assuming individuals starting to work at the age of 25 and going into retirement at the age of 65. Payment length of the savings is set to 5,10,15,20,25 and 30 years after retirement.

Furthermore individuals are assumed to have 31.6, 51.6 or 56.6 percent income and state tax when saving and receiving payment from IPS or 30 percent capital tax when selling stocks on the stock exchange or receiving dividends. The IPS savings and payment will also be charged with tax on earnings. The tax on earnings are assumed to be constant during saving and payment period which imply that 0.645% will be charged on the IPS holdings each year. These different amounts of yearly savings will be compared and evaluated with respect to different length of saving years, different length of payment years, different re-turn and different income and state taxes.

This thesis does not consider administration costs or commission fees charged by institu-tions and banks.

1.5 Former Research

There exists a substantial amount of studies regarding pension systems e.g. The gains from pension reform written by Assar Lindbeck and Mats Persson (2002), Intergenerational Risk

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Sharing, Stability and Optimality of Alternative Pension Systems written by Assar Linbeck and John Hassler (1997) and Pension systems and reforms written by Agneta Kruse (1997). These studies concentrates on the stability of the pension systems. There are also some studies concerning private pension saving e.g. The Impact of Wealth on Tax-Deffered Pen-sion Saving written by Inger Johannisson (2002), but none of them present any calculations that really shows how much an individual benefit or loose when saving money for retire-ment. Therefore the author’s intention has been to calculate these figures.

1.6 Outline

The outline of this thesis is as follows: Section 2 discusses consumption and saving. It starts with the explanation of consumption and saving behavior in a two period model and continues with the Life-Cycle Hypothesis in explaining saving and consumption in the long run. The saving and consumption behavior will then be connected to uncertainty and taxes. Section 3 contains a description of the five Swedish saving types for retirement. Then it continues with presentation and discussion of differences in return before and after pay-ments in Section 4. In Section 5 conclusions drawn from previous sections will be ex-plained and finally there will be suggestions for future studies.

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2 Consumption or Saving?

This section explains individual’s preferences concerning consumption and saving. It will explain the mecha-nisms for saving behavior using a micro economic approach, through the life-cycle and permanent income hy-pothesis and uncertainty. It will furthermore explain how taxes in Sweden can affect individuals saving pat-tern.

What is saving?

According to Romer (2003), saving (S) is future consumption. The amount of money an individual does not consume (C) out of its income (Y) is considered as savings. Savings equal income minus consumption (S=Y-C). If an individual does not save money just for the sake of saving, than he or she save money for the possibility to consume in the future.

Why do some individuals save money for the future?

2.1 A Micro Economic Approach

According to Schotter (2003), people save money only if the amount of interest (return on capital) on their savings is enough to make them want to postpone current consumption for future consumption. In the most simple case assuming competitive financial markets, a two period horizon and an income of 10,000 SEK today and zero tomorrow, one can see in Figure 2.1 that an individual can consume its income either today or tomorrow. The budget line for this individual goes through point A and B, where the slope of the budget line is the attainable market interest rate -(1+r). This implies that if the interest rate is 10% an individual can consume 10,000 SEK today and zero tomorrow (point A), zero today and 11,000 SEK tomorrow (point B) or somewhere between these points on the budget line. Depending on the individual’s preferences, represented by the indifference curve, he or she will allocate consumption where the indifference curve is tangent to the budget line. In this case equilibrium is reached at point C, where the marginal rate of substitution for an indi-vidual between consumption today and tomorrow equals the interest rate.

Figure 2.1 Budget Line

Source: Schotter (2003)

At point C consumption is equal to 5,000 SEK and savings equals 5,000 SEK today. The individual invests 5,000 SEK today and receives interest on the investment for one period, which implies 5,500 SEK tomorrow. Depending on the level of interest rate and prefer-ences individuals will have different incentives to save. As one can see in Figure 2.2 a higher interest rate can induce saving.

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Figure 2.2 Interest Rate Changes

Source: Schotter (2003)

When the interest rate increases from 10 to 20 percent the slope gets steeper and consump-tion today decreases from point D to point F. At the same time consumpconsump-tion tomorrow increase. This is true for circumstances when consumption tomorrow can be viewed as a superior good3_{. In the case of an inferior good}4_{the opposite would be the case. Therefore}

an increase in interest rate may not have the effect of a reduction in current consumption and an increase in current saving. This is due to the fact that a change in interest rate not only has a substitution effect, but it also has an income effect. This can especially be true for situations when individuals are net savers and there is an increase in the interest rate. Looking at Figure 2.3 starting from point G, where income in period one equals consump-tion in the same period (saving equals zero) and income in period two equal’s consumpconsump-tion in the same period. If the interest rate increases the slope gets steeper and consumption in period one decreases (saving for period two), and consumption in period two increases. This scenario illustrates the substitution effect. (Romer, 2001)

3_{A good for which demand increases as the income inreases and relative prices stay constant} 4_{A good for which demand decreases as the income increases and relative prices stay constant}

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Figure 2.3 Substitution effect

Source: Romer (2001)

Continuing to Figure 2.4 we can observe both a substitution and an income effect. In point I, the individual is already a saver, which implies that the interest rate increase will have a positive income effect. The individual can have a larger consumption in both periods. The substitution effect increase saving and the income effect decrease it. In this case saving will decrease in period one, but consumption will increase in both periods. (Romer, 2001)

Figure 2.4 Substitution effect and positive income effect

If the individual is a borrower, then as Figure 2.5 demonstrates, an increase in the interest rate will increase savings because both the income and the substitution effect reduce first period consumption. This implies moving from point K to point L.

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Figure 2.5 Substitution effect and negative income effect

To conclude, the total stock of financial wealth in the economy is positive which implies that individuals are on average net savers rather than borrowers5_{. Therefore one can expect}

in general that the income effect is positive when the interest rate rises. As a result an in-crease in the interest rate has two competing effects on overall saving, positive through the substitution effect and a negative one through the income effect. (Romer, 2001)

But what motivates people to save in the long-run? Does it payoff to save in the long-run?

2.2 Life-Cycle and Permanent Income Hypothesis

The life-cycle theory was originally developed by Modigliani and Brumberg (1954). It as-sumes that individuals plan their consumption and savings over extended periods, with the intention to allocate consumption in an optimal way over their entire lifetimes. The theory suggests the existence of several marginal propensities to consume (MPC’s6_{). It implies}

dif-ferent MPC’s for permanent income, transitory income and wealth. One of the most im-portant assumptions is that individuals prefer a stable lifestyle, i.e. consuming at the same level every period and that information about labor incomes for each individual from the present to the future is given.

The theory links consumption and saving patterns to demography. The marginal propen-sity to consume of permanent income depends on age. As an individual becomes older, the number of years to live declines and so do the number of working years. On the other hand the MPC of transitory income increases. If an individual have a positive transitory come one year it have to be spread over both working years and non-working years. If in-stead an individual receive a permanent income, this income will last during the whole working period not just one year as in the transitory case. This will also have the same spread as the transitory income but the effect will be different, hence marginal propensity

5_{Source: SCB-Sparbarometern 2006.}

6_{Marginal propensity to consume (MPC) is the amount of increase in consumption when income increase}

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to consume for transitory income is small (close to zero) and the MPC for permanent in-come is large. (Dornbusch, Fischer and Startz, 2004)

The theory also suggests that the MPC out of wealth should be small, as for transitory in-come, because it is spread over the remaining years of life. The MPC for wealth is used as a link between changes in asset values and current consumption. It implies that an increase in the stock market also increases current consumption.

As one can see in Figure 2.3 consumption (C) is constant during the whole lifetime. During working life (WL) the individual have an income YL and save money ((YL*WL)-C) and therefore accumulate assets. These assets are then used after working life (WL-NL) until the assets equal zero.

Figure 2.6 Life-Cycle Model

Source: Dornbusch, Fischer and Startz (2004)

The permanent-income hypothesis originally developed by Milton Friedman (1957), sug-gests that consumption is not related to current income but instead to a longterm estimate of income which is called permanent income. The theory is focused on forecasting the level of income accessible to an individual over a lifetime. According to this theory people prefer to have a constant consumption flow rather than a volatile with a high income today or tomorrow and low income yesterday or today. The definition of permanent income is the constant rate of consumption a person can maintain during the rest of his/hers lifetime, given the present level of earned income and wealth, now and in the future. This imply that if the permanent income increases for an individual it will affect consumption with an in-crease, but if it is a transitory income it will not have any substantial affect on consumption at all. Today these two theories are considered as one (LC-PIH).

What are the implications on saving and consumption?

According to Dornbusch Fischer and Startz (2004), given a certain income an individual consumes the same amount for the rest of his/hers life. Suppose an individual has a per-manent income rise, this implies that consumption increases, but it is smoothened out over the following years. If the income rise is temporary, it will not have any large impact on consumption or saving. The theory suggests that any temporary increase or decrease in in-come only has a small effect on consumption due to the fact that inin-come is spread over many years, while a permanent raise increase consumption.

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This implies that individual saving is high when transitory income is high and when transi-tory income is smaller than permanent income, individuals have negative saving. Individu-als save and borrow money to smooth consumption over their life time. (Romer, 2001).

2.3 Uncertainty

Considering that future income is uncertain there exist some evidence that individuals save for precautionary reasons. According to Wärneryd (1999), precautionary saving can be di-vided into two types, short-run and long-run. The short-run is a buffer saving for unfore-seen events in the future and the long-run is a cover against income variations. This implies that saving for retirement is a long-run precautionary saving, which can be explained by the LC-PIH theory.

Short-run savings are used as a buffer stock, where it grows when having a high income and declines when having a small income. The risk of having a decreased income is more painful for an individual, than the benefit of an equal increase in income. One way to coun-teract this is through buffer stock saving. (Dornbusch, Fischer and Startz, 2004)

According to Romer (2001), most households are buffer-stock (short-run) savers when they are young, but begin to save for retirement (long-run) once they reach middle age. Therefore precautionary savings and uncertainty of future income affect consumption and therefore savings. If one considers the existence of welfare programs, this implies that an individual who have a probability of going on welfare will have fewer incentives to save money for the future. This has a negative effect on savings because the welfare program works as an insurance against low income and it imposes high taxes on savings. For indi-viduals that the probability of going on welfare is negligible, consumption and savings ex-hibit life-cycle saving.

2.4 Taxes

In Sweden there exist a wide range of different taxes. The most important one’s, when fo-cusing on savings for retirement are municipality tax (income tax), state tax, capital tax, tax on earnings and wealth tax. As one can see in Table 2.1 the average municipality tax across the country is 31.6%. If one has a higher earned income than 306,000 SEK the tax is in-creased by a state tax of 20% up to an earned income of 460,600 SEK. Above that amount the state tax is 25%, totally paying an income tax of 56.6% of the earned income above 460,600 SEK.

Table 2.1 Swedish Tax Rates

Type Tax Rate Accumulated

Municipality Tax

Within income range: 0 – 306,000 SEK

Ave: 31.6% 31.6%

State Tax 1

Within income range: 306,001-460,600 SEK

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State Tax 2

Within income range: Above 460,600 SEK

25% 56.6%

Capital Tax 30%

Wealth Tax 1.5%

Source: Skatteverket (2006)

The tax on capital return i.e. return on deposits, dividends and net profit of sales of stocks is 30%. The tax on wealth is 1.5% of the amount that exceed 1500,000 SEK for singles or single parents with children below 18 and 1.5% of the amount that exceed 3000,000 SEK for jointly taxed individuals.

As a starting point one can say that taxes must be charged by force. Individuals would not pay taxes voluntarily. This implies that individuals try to avoid tax as much as possible. Secondly the purpose of taxes is to finance the public sector and to achieve some distribu-tion of income from those who are wealthier to those who are poorer. The main ambidistribu-tion from an effective point of view is to minimize individual’s behavior due to taxes, provided that the tax is not imposed deliberately for a certain behavior. The main public income in Sweden consists of taxes that are imposed on wage earnings. In Sweden there exist three types of individual income tax i.e. earned income, income of business activity and income of capital. As one can see form Table 2.1 the tax on earned income is progressive, while the capital tax is proportional. An individual who pays high earned income tax ( i.e. municipal-ity tax and state tax), will try to lower the earned income by receiving the money as income of capital. The definition of income of capital is the difference between gross return and net return. This means that corporate tax, capital tax, property tax, wealth tax and tax on earnings are all considered as tax on capital. Tax on earned income, welfare dues and con-sumption taxes are all considered as tax on work. Current tax system was imposed in the beginning of the 1990s in Sweden. (Norrman, 2000)

Relating taxes to the two period microeconomic approach, an introduction of a capital tax will decrease the slope of the budget line. The new slope is –(1+(1-t)r), where t is the capi-tal tax rate. As one can see in Figure 2.7, due to both income and substitution effect one moves from point M to point N. This imply in this case that an individual decrease saving and increase consumption at present and decrease consumption in the future.

Figure 2.7 Tax effect

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Regarding taxes and the LC-PIH theory stated in the previous subsection a temporary tax reduction has no large impact on savings and consumption, only permanent reduction has an impact. The micro economic approach argues that individuals will save money for the future if they consider that the rate of return is large enough to postpone consumption to-day to consumption in the future. Taxes in general have a decreasing effect on savings in the present. The LC-PIH theory suggests that individuals gain from saving money to re-tirement, due to the assumption that individuals prefer a smooth consumption during their lifetime. The only possible way to achieve this is to save money when income is high.

If an individual then decides to save money for retirement what kind of pension related saving possibilities exist today? From the theories of consumption and saving we continue with existing saving alternatives in Sweden.

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3 Which Possibilities of Saving Exist Today?

This section lists available pension related saving alternatives for retirement in Sweden and there characteris-tics.

3.1 Traditional Pension Insurance

Traditional pension insurance can only be administrated by an insurance company (Kon-sumenternas försäkringsbyrå, 2006). The insurance company decides by itself how to invest the money the individual have saved. It can be viewed as a mixed fund, where the money can be invested in stocks, bonds or real estate. (Nyman, 1999)

The individual is guaranteed a certain rate of return or interest, but if the insurance com-pany achieves a higher return it will also be added to the individuals account, this extra money is called bonus. If one chooses this type of pension saving the money invested can not decrease from one year to another no matter the development of stocks or interest rates. (Nyman, 1999) The insurance company guarantees a return of 2.5-3% (2006) before tax on earnings and administration costs. If the insurance company will have a low return, it can take the bonus that has been paid to the insured. This implies that there is a probabil-ity that no bonus will be paid, hence the insurance company guarantee for sure to pay back the individuals payment plus the guaranteed interest minus tax on earnings and administra-tion costs. (Konsumenternas försäkringsbyrå, 2006)

The amount of money an individual save each year is tax deductible, but the money re-trieved when going into retirement will be taxed according to the existing income tax rate at the time of retirement. One can deduct up to a half price base amount (19,850 SEK 2006)7 _{or 5% of the income up to a maximum of one price base amount (39,700 SEK}

2006) of the earned income.

Table 3.1 Tax Deduction 2006

Income [SEK] Tax Deductible [SEK]

0 – 397,000 19,850

397,000- 794,000 5% of income up to 39,700

794,000 - 39,700

Source: Skatteverket (2006)

The tax on earnings is 15%. It is charged on the 1st_{of January each year. The tax basis is}

calculated by multiplying the insurance value by last year’s average governmental interest rate, which was 4.30% (2004)8_{. Therefore the tax was (4.30%*15%), which is 0.645% of the}

pension insurance value 1st_{of January 2006. This means that it does not matter what}

re-turn one has received from the insurance during the year. The savings are free from wealth tax. (Konsumenternas försäkringsbyrå, 2006)

7_{Source: Skatteverket 2006.}

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When going into retirement, the payments are income taxed, furthermore the money can not be retrieved before the age of 55. An individual can not receive the whole amount in a lump sum, the payment must be spread over at least 5 years and can be paid for the rest of the individuals life. This insurance is also available with survivors' protection. This implies that in case of death, the insurance will be transferred to individuals within the family. This involves a certain cost that reduces future payments of the insurance. (Konsumenternas försäkringsbyrå, 2006)

3.2 Mutual Fund Insurance (Unit-linked)

This possibility of pension insurance is also only administrated by insurance companies, even though they use banks as commissioners. In mutual fund insurance the individual de-cides how the money should be invested in the different funds. The rate of return of the investment depends on the individuals own knowledge about the financial market. There are no guarantees that the amount of money that will be paid when going into retirement. It all depends on the development of the funds. In this case one can change funds during the time before retirement. An individual can change funds within an insurance company or change funds between different insurance companies. One may be charged a fee when changing funds. (Nyman, 1999)

The rules for deductibility, taxing, payment, spread etc. is the same as in the case for tradi-tional pension insurance. However, due to the fact of no guaranteed return, it can be the situation that one have to pay tax on the saved value even though the return have been equal to zero or negative. (Konsumenternas försäkringsbyrå, 2006)

3.3 Individual Pension Saving (IPS)

Only pension saving institutes that are authorized by the Swedish Financial Supervisory Authority that can offer IPS. This implies that IPS can be operated by banks, security com-panies, companies with permission to operate securities business and foreign securities companies with a branch establishment in Sweden.

The savings can be invested in Swedish or foreign mutual funds, in Swedish or foreign stocks and bonds that are registered at a stock exchange or at an authorized marketplace or in a bank account at a Swedish or a foreign bank. One can transfer a certain part of the funds or the whole fund during the saving period or the payment period between existing mutual funds, stocks or bank accounts. Furthermore each individual can change pension institute during saving or payment period, but this imply that the current institute can charge a fee, which will be deducted from the pension account. The savings in IPS can only be made through cash deposits, i.e. an individual can not move existing funds or stocks into IPS.

Rate of return on the investment depends on the individuals own knowledge about the fi-nancial market. There are no guarantees regarding the amount of money that will be paid when going into retirement. It all depends on choices made by each individual saver. Payments into IPS are tax deductible, the same rules apply for IPS as for traditional pen-sion insurance and unit linked. Tax on earnings and its calculations are also the same for IPS as for traditional pension insurance and unit linked. This means that it does not matter what return one have received from the insurance during the year, one still have to pay tax.

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This also implies for IPS as for unit linked, that if one is having zero or negative return on savings one still have to pay tax. The IPS is free from wealth tax.

When going into retirement the payment from IPS is income taxed. The money can not be retrieved before the age of 55. Furthermore one can not receive the whole amount in a lump sum but the payment must be spread over at least 5 years and can be paid for the rest of the individual’s life, and usually individuals choose 10 or 20 years. This pension saving form is a saving product without any insurance features, but one can supplement with a separate insurance e.g. group life insurance. In the case of death, the IPS has no survivors' protection, but instead there is a repayment protection. This protection implies that money will be transferred to estate or beneficiary (if stated). The IPS is not insured by the state guarantee of deposits. (Konsumenternas Bank-& Finansbyrå, 2006)

3.4 Capital Insurance

Capital insurance is a life insurance. It can be invested in a mutual fund or a traditional in-surance with a guaranteed interest of 3% minus tax on earnings and fees. Capital inin-surance is not tax deductible, but one does not pay any tax when retrieving the money. The indi-vidual choose by itself for how long he/she wants to save money before retrieving it. Usu-ally at least five to ten years. The tax on earnings is 27%, this imply that the tax charged on the capital insurance is 1.161% (27%*4.30%) this year. (Konsumenternas försäkringsbyrå, 2006)

If one’s assets together with the capital insurance exceed 1.5 million SEK one will also be charged wealth tax. For couples who are taxed together the limit is 2.0 million SEK instead. Some capital insurances are paid as a lump sum, while others are paid on a longer period as pensions. Depending on the insurance company’s terms, it is possible that the insurance can be repurchased prematurely by the insurance company. (Konsumenternas försäkrings-byrå, 2006)

3.5 Capital Pension Insurance

Using capital pension insurance implies a possibility to invest in mutual funds and separate stocks on the stock exchange (some institutes supply only mutual funds). The return on capital is all depending on the individual’s own knowledge of the capital market. Some of the institutes also demand a certain amount of deposit when opening an account. The rules for deductibility and taxes on payments are the same for Capital pension insurance as for Capital insurance. The savings are free from wealth tax and the insurance company guaran-tees a certain interest rate. The tax on earnings is 15%, this imply that the tax charged on capital insurance is 0.645% (15%*4.30%). (Konsumenternas försäkringsbyrå, 2006)

The money can not be retrieved before the age of 55 and the payment must be spread over at least 5 years. Capital insurance is also available with survivors' protection. This implies that in case of death, that the insurance will be transferred to individuals within the family. The savings are free from wealth tax. (Konsumenternas försäkringsbyrå, 2006)

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Table 3.2 Summary of saving characteristics

Type of

saving ductibilityTax De- Wealth Tax EarningsTax on Payments ProtectionSurvivors’

Traditional Pension In-surance YES NO 15% Income Taxed Available Mutual Fund

Insurance YES NO 15% IncomeTaxed Available

Individual Pension Sav-ing (IPS) YES NO 15% Income Taxed No (Repayment protection ) Capital In-surance

NO YES 27% NOT Taxed Available

Capital Pen-sion

Insur-ance

NO NO 15% NOT Taxed Available

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4 Results and Analysis

Considering the saving alternatives stated in section three, especially IPS, will an individual benefit from us-ing IPS to save for retirement or will he or she gain more from savus-ing money for retirement on the stock ex-change? This section presents some of the results that have been calculated by the author. Subsection 4.1, 4.2 and 4.3 demonstrate the differences in return before payments. Subsection 4.4 explains reason for cho-sen length of payment periods (duration), subsection 4.5 and 4.6 demonstrates the differences in payments between IPS and OMX and finally, subsection 4.7 discusses the advantages and disadvantages of the two systems from an income perspective.

According to London Business School and ABN AMRO9_{the real rate of return for}

equi-ties and bonds in Sweden during the period 1900-2005 were 7.8% and 2.5%. In this analy-sis a range from 2 to 12% have been chosen.

4.1 Income Tax 31.6%

Assuming that an individual has a tax rate of 31.6%, which implies a maximum earned in-come of 306,000 SEK (2006). In this case the individual can deduct zero to 19,850 SEK from earned income if he or she uses the money for private pension saving in the IPS sys-tem. The holdings in the IPS will be charged with tax on earnings each year. If instead one buys stocks directly on the stock exchange (OMX), one have to use income taxed money. Individuals are assumed to want to save equal amounts of money. This implies for an indi-vidual that is using IPS that he or she can save the whole amount, but for the indiindi-vidual that uses the OMX has to pay tax first. The IPS saver can therefore save more money for pension than the OMX saver. Therefore by saving in IPS one can save 19,850 SEK, but if saving on the stock exchange one can only save 13,577.40 SEK (19,850*0.684). As one can observe in Table 4.1, calculating the differences in return between the systems, the IPS gives a higher return than the OMX before payment, when saving 19,850 SEK each year.

Table 4.1 IPS-OMX before payment. S=19,850 SEK. T=31.6%

Year Ret[2%] Ret[4%] Ret[6%] Ret[8%] Ret[10%] Ret[12%]

10 62,116 69,198 77,161 86,113 96,175 107,482 20 121,509 149,485 185,398 231,638 291,313 368,453 30 175,252 237,607 328,967 464,091 665,396 966,903 40 219,448 325,421 501,698 800,554 1314,622 2,208,164

Source: Author’s calculation

As one can see in the Table 4.1, saving 19,850 SEK for 10 years with a real rate of return equal to 8% gives 86,113 SEK more than OMX. Saving for 40 years gives 800,554 SEK more money than OMX. Even with a smaller amount of saving i.e. 2,400 SEK each year IPS outperform OMX. This can be seen in Table 4.2 below. At a real rate of return of 8% and 10 years of saving gives 10,412 SEK more than OMX, saving 40 years gives 96,792 SEK extra.

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10 7,510 8,366 9,329 10,412 11,628 12,995 20 14,691 18,074 22,416 28,007 35,222 44,548 30 21,189 28,728 39,774 56,112 80,451 116,905 40 26,533 39,346 60,659 96,792 158,947 266,982

The comparison between the two systems indicates that IPS outperforms OMX before payments in all cases when tax equals 31.6% at the time of saving.

4.2 Income and State Tax 51.6%

Assuming that an individual has an income tax of 31.6% and a state tax of 20% (totally 51.6%), implies that an individual have earned income between 306,001 and 460,600 SEK (2006). In this scenario the individual can deduct zero to 19,850 SEK plus an additional amount of 5% of the income between 397,000 to 794,000 SEK from its earned income if he or she uses the money for private pension saving in the IPS system. This implies that within the earned income range of 306,001 to 460,600 one can deduct a maximum of 23,030 SEK. As one can see in Table 4.3 IPS clearly outperforms OMX before payments.

10 123,511 137,796 153,875 17,1971 192,331 215,229 20 255,126 316,077 394,699 496,389 628,171 799,178 30 393,921 544,332 767,659 1,101,964 1,605,419 2,366,770 40 538,379 832,749 1,337,675 2,217,475 3,767,666 6,519,125

Continuing the comparison, one can see in Table 4.4 that also at a smaller saving rate the IPS outperform OMX before payments.

10 12,871 14,360 16,036 17,921 20,043 22,429 20 26,587 32,939 41,132 51,730 65,463 83,284 30 41,051 56,726 79,999 114,838 167,304 246,646 40 56,106 86,782 139,402 231,087 392,636 679,370

Comparing Table 4.2 and Table 4.4 one can see that after 10 years of saving, with a saving rate of 2,400 SEK each year and a real rate of return equal to 8% the difference is 7,509 SEK, which is a 72.1% higher return when tax rate is 51.6% in comparison to when tax rate is 31.6% in favor for IPS.

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4.3 Income and State Tax 56.6%

Assuming that an individual has an income tax of 31.6% and a state tax of 25% (totally 56.6%), implies that an individual has earned income above 460,600 SEK (2006). In this scenario an individual can deduct zero to 19,850 SEK plus an additional amount of 5% of the income between 397,000 to 794,000 SEK from earned income. This implies that within the earned income above 460,600 one can deduct a maximum of 39,700 SEK. As one can see in Table 4.5 IPS clearly outperform OMX before payment, when saving 39,700 SEK each year.

10 235,082 262,323 292,990 327,507 366,347 410,035 20 488,992 606,339 757,799 953,799 1,207,925 1,537,840 30 761,194 1,054,122 1,489,666 2,142,464 3,126,656 4,616,459 40 1,050,375 1,631,696 2,631,570 4,377,934 7,461,248 12,943,317

Furthermore looking into Table 4.6, the IPS clearly outperform OMX also when saving 2,400 SEK per year.

10 14,212 15,858 17,712 19,799 22,147 24,788 20 29,561 36,655 45,812 57,660 73,023 92,968 30 46,017 63,725 90,055 129,519 189,017 279,081 40 63,499 98,642 159,087 264,661 451,058 782,468

The results in subsection 4.1, 4.2 and 4.3 show clearly that the return before payments are larger for IPS than OMX even though the IPS is charged with tax on earnings each year on the holdings. The taxed charged is very low compared to the deduction ability and there-fore saving within the IPS system clearly gives a larger monetary return than saving on the OMX before payment.

4.4 Duration

Considering the return before payment, we move on in our analysis with the return after payment.

According to Statistics Sweden (SCB) the expected remaining life length after 65 years of age is increasing. As one can see in Figure 4.1 it is 17.25 for men and 20.40 for women in the year of 2005 and expected to be 20.80, respectively 22.94 in the year of 2050. Consider-ing the assumption that individuals retire at the age of 65, therefore a reasonable duration of payment should be between 5 to 25 years. In this analysis a payment period (duration) from 5 to 30 years has been chosen.

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Remaining duration of life at 65 years of age 12,00 14,00 16,00 18,00 20,00 22,00 24,00 26,00 28,00 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 Year Years Men Women

Figure 4.1 Remaining duration of life after 65 years of age

Source: Statistics Sweden

4.5 Payment Income Tax 31.6%

The analysis continues with the comparison of payments received when going into retire-ment. In this case the income tax is assumed to be 31.6% when saving and the same when receiving the money (as a pensioner). The capital tax equal 30% on the profit when realiz-ing stocks on the OMX. Tax on earnrealiz-ings is assumed to be 0.645% and is charged on the holdings in the IPS each year. As one can see in Table 4.7 the IPS outperform OMX when real return is above 2%, but when real return is below or equal to 2%, the IPS is outper-formed by the OMX. If an individual save 2,400 SEK for 20 years and the real rate of re-turn equals 8%, he or she will then receive 1,304 SEK more money each year during a ten year period if he or she uses the IPS system instead of the OMX. If instead the real rate of return is 2%, then OMX will yield 107 SEK more money than the IPS each year.

Table 4.7 IPS-OMX. Duration 10 years. S=2,400 SEK T1=31.6% T2=31.6%

10 -32 kr 80 kr 216 kr 380 kr 578 kr 816 kr 20 -107 kr 222 kr 676 kr 1,304 kr 2,173 kr 3,375 kr 30 -253 kr 372 kr 1,352 kr 2,906 kr 5,388 kr 9,374 kr 40 -510 kr 415 kr 2,043 kr 4 ,974 kr 10,342 kr 20,297 kr

In Table 4.8, where 19,850 SEK is saved each year, similar result is achieved as in Table 4.7.

10 -268 kr 661 kr 1,787 kr 3,146 kr 4,783 kr 6,745 kr 20 -883 kr 1,836 kr 5,590 kr 10,783 kr 17,969 kr 27,915 kr 30 -2 091 kr 3,073 kr 11,179 kr 24,032 kr 44,565 kr 77,529 kr 40 -4 217 kr 3,431 kr 16,895 kr 41,137 kr 85,541 kr 167,871 kr

It appears as if the effect of tax on earnings and income tax for IPS, when retrieving the money has a negative impact on payments when duration is increased, but still outperform

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the OMX in all cases except when real rate of return is equal or less than 2% (see Appendix A and B).

Suppose that an individual pays an income and a state tax equal to 51.6% during the saving period and an income tax of 31.6% when receiving the payment, then one can observe in Table 4.9 that the IPS outperform the OMX in all cases.

10 529 kr 741 kr 998 kr 1,308 kr 1,681 kr 2,128 kr 20 1,108 kr 1,793 kr 2,744 kr 4,067 kr 5,906 kr 8,462 kr 30 1,727 kr 3,220 kr 5,609 kr 9,464 kr 15,715 kr 25,879 kr 40 2,371 kr 5,085 kr 10,108 kr 19,559 kr 37,541 kr 71,963 kr

In Table 4.10 where 23,030 SEK is saved each year, one can observe similar results as in Table 4.9.

10 5,080 kr 7,112 kr 9,575 kr 12,550 kr 16,130 kr 20,423 kr 20 10,635 kr 17,204 kr 26,331 kr 39,022 kr 56,671 kr 81,200 kr 30 16,573 kr 30,897 kr 53,825 kr 90,814 kr 150,795 kr 248,333 kr 40 22,748 kr 48,793 kr 96,992 kr 187,689 kr 360,234 kr 690,546 kr

The overall result indicates that when income and state tax is equal to 51.6% during the saving period and income tax is equal to 31.6% when receiving payment, the IPS outper-form OMX. Number of saving years, duration or real return do not affect this result (see Appendix A and B).

Finally considering the case when an individual pays an income and state tax equal to 56.6% when saving and 31.6% when retrieving the money, one can again observe in Table 4.11 that IPS outperform OMX.

Table 4.11 IPS-OMX. Duration 10 years. S=2400 SEK T1=56.6% T2=31.6%

10 634 kr 870 kr 1,157 kr 1,504 kr 1,921 kr 2,421 kr 20 1,340 kr 2,114 kr 3,189 kr 4,685 kr 6,767 kr 9,662 kr 30 2,114 kr 3,824 kr 6,566 kr 10,996 kr 18,188 kr 29,898 kr 40 2,947 kr 6,108 kr 11,980 kr 23,062 kr 44,196 kr 84,736 kr

In Table 4.12, where an individual saves 39,700 SEK each year, results are similar as in Ta-ble 4.11, IPS outperform OMX

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10 10,484 kr 14,399 kr 19,144 kr 24,874 kr 31,769 kr 40,040 kr 20 22,167 kr 34,963 kr 52,752 kr 77,502 kr 111,938 kr 159,821 kr 30 34,970 kr 63,254 kr 108,607 kr 181,884 kr 300,863 kr 494,556 kr 40 48,745 kr 101,041 kr 198,169 kr 381,482 kr 731,080 kr 1,401,670 kr

To sum up, the analysis indicates that IPS should be used instead of OMX when an indi-vidual pays both income and state tax during the saving period and income tax when trieving the payment. In the case when an individual has income tax when saving and re-trieving the money one should expect to have a real return above 2%, otherwise it will not feasible to use IPS (see further results in Appendix A and B).

4.6 Payment Income and State Tax 51.6% and 56.6%

If an individual have income and state tax both when saving and retrieving the money the following results will appear.

Assuming that income and state tax is 51.6% both when saving and retrieving payment then as one can observe in Table 4.13 IPS outperform OMX, except for real returns equal to 2%.

10 -27 kr 53 kr 149 kr 265 kr 405 kr 573 kr 20 -84 kr 148 kr 468 kr 911 kr 1,524 kr 2,371 kr 30 -193 kr 246 kr 935 kr 2,027 kr 3,771 kr 6,570 kr 40 -382 kr 266 kr 1,403 kr 3,450 kr 7,193 kr 14,126 kr

Continuing with the scenario where an individual saves 39,700 SEK each year and have same tax rate as in previous example, one can see in Table 4.15 that IPS gives a larger pay-ment each year than OMX if real rate of return is above 2%. If it is equal to 2% implies that OMX gives a larger payment each year than IPS.

10 -441 kr 872 kr 2,463 kr 4,384 kr 6,697 kr 9,470 kr 20 -1,387 kr 2,448 kr 7,744 kr 15,068 kr 25,202 kr 39,225 kr 30 -3,189 kr 4,075 kr 15,472 kr 33,537 kr 62,386 kr 108,684 kr 40 -6,315 kr 4,393 kr 23,216 kr 57,062 kr 118,983 kr 233,673 kr

These results are also true for cases when duration is 5 years or longer than 10 years (see further results in Appendix C).

Assuming that income and state tax equal 56.6 % when saving and retrieving payment then as one can see in Table 4.15 IPS outperform OMX when real return is above 2% and dura-tion is 10 years.

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10 -61 kr 10 kr 96 kr 200 kr 326 kr 476 kr 20 -150 kr 58 kr 345 kr 742 kr 1,292 kr 2,052 kr 30 -284 kr 109 kr 727 kr 1,706 kr 3,270 kr 5,780 kr 40 -491 kr 89 kr 1,110 kr 2,944 kr 6,301 kr 12,518 kr

Continuing with the scenario where an individual saves 39,700 SEK each year and the tax rate is 56.6%, the similar result will appear as in the previous example. In Table 4.16 IPS outperform OMX if real rate of return is above 2% and OMX outperform IPS when real rate of return is equal to 2%. These results are also true for duration periods larger than 10 years, but not for a duration period of 5 years or when duration is 10 years and number of saving years is less then ten (see Appendix C).

10 -1,011 kr 166 kr 1,593 kr 3,316 kr 5,390 kr 7,877 kr 20 -2,474 kr 965 kr 5,714 kr 12,281 kr 21,368 kr 33,942 kr 30 -4,705 kr 1,808 kr 12,028 kr 28,227 kr 54,095 kr 95,611 kr 40 -8,123 kr 1,479 kr 18,357 kr 48,706 kr 104,231 kr 207,073 kr

In the case of a shorter saving period than 10 years, there is a change in the pattern of pay-ments when having an income and state tax equal to 56.6% both before paypay-ments and after payments. As one can observe in Table 4.17 OMX outperforms IPS when the real rate of return equals or is below 4%.

Table 4.17 IPS-OMX. Duration 10 years. S=2,400 SEK T1=56.6% T2=56.6% Saving 5 years

1 -10 kr -5 kr 0 kr 6 kr 11 kr 17 kr 2 -20 kr -9 kr 3 kr 15 kr 29 kr 43 kr 3 -31 kr -12 kr 8 kr 30 kr 53 kr 78 kr 4 -42 kr -14 kr 16 kr 49 kr 84 kr 122 kr 5 -53 kr -15 kr 27 kr 72 kr 123 kr 178 kr

Continuing with the same tax rate and situation as before but with a saving rate of 39,700 SEK each year, similar results can be seen in Table 4.18.

Table 4.18 IPS-OMX. Duration 10 years. S=39,700 SEK T1=56.6% T2=56.6% Saving 5 years

1 -168 kr -85 kr 1 kr 92 kr 186 kr 285 kr 2 -339 kr -153 kr 45 kr 254 kr 475 kr 708 kr 3 -514 kr -203 kr 132 kr 490 kr 874 kr 1,283 kr 4 -694 kr -236 kr 263 kr 804 kr 1,390 kr 2,023 kr 5 -878 kr -251 kr 439 kr 1,198 kr 2,031 kr 2,943 kr

In the case of a duration period of 10 years, OMX outperforms IPS when real rate of re-turn is 4% or below and when the number of saving years are five or below 5 years. Longer

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duration periods shows that IPS outperform OMX in all cases except for when real rate of return equal or is below 2% (see Appendix D).

The calculations also indicates that for all chosen saving rates and a duration period of 5 years the OMX outperform IPS when real rate of return is below or equal 4% and the number of saving years is eleven or below. If the number of saving years are twelve or above the OMX outperform the IPS only in the 2% situation (see Appendix D).

4.7 High-income earners versus Low-income earners

Who benefits from using IPS? Is it high-income earners or low-income earners?

Looking into Table 4.19 one can observe that low-income earners do not gain anything if they save money in the IPS system when real rate of return is low. It is better to invest di-rectly on the stock exchange. This indicates that low-income earners should not use the IPS system if they want to invest in low risk securities.

Table 4.19 Low-income earner. IPS-OMX. Duration 5 years. Saving 10 years

Saving/year Ret[2%] Ret[4%] Ret[6%] Ret[8%] Ret[10%] Ret[12%]

2,400 kr -52 kr 120 kr 322 kr 559 kr 836 kr 1,160 kr 4,800 kr -104 kr 240 kr 644 kr 1 117 kr 1,672 kr 2,321 kr 9,600 kr -209 kr 480 kr 1,288 kr 2,235 kr 3,344 kr 4,641 kr 12,000 kr -261 kr 600 kr 1,610 kr 2,794 kr 4,180 kr 5,801 kr 19,850 kr -432 kr 992 kr 2,663 kr 4,621 kr 6,914 kr 9,596 kr 23,030 kr -501 kr 1,151 kr 3,089 kr 5,362 kr 8,022 kr 11,134 kr 39,700 kr -864 kr 1,984 kr 5,325 kr 9,242 kr 13,829 kr 19,193 kr

For high-income earners it is always beneficial to use IPS instead of OMX, when the tax at payment only consists of a municipality tax. Looking into Table 4.20 one can observe that high-income earners gain the most when real rate of return is high compared to the lower rate of return. This indicates that high-income earners should use IPS instead of OMX if they prefer to invest in high risk securities.

Table 4.20 High income earner. IPS-OMX. Duration 5 years. Saving 10 years

Saving/year Ret[2%] Ret[4%] Ret[6%] Ret[8%] Ret[10%] Ret[12%]

2,400 kr 1,231 kr 1,586 kr 2,003 kr 2,493 kr 3,066 kr 3,738 kr 4,800 kr 2,462 kr 3,172 kr 4,006 kr 4,985 kr 6,133 kr 7,477 kr 9,600 kr 4,924 kr 6,344 kr 8,012 kr 9,970 kr 12,265 kr 14,953 kr 12,000 kr 6,155 kr 7,930 kr 10,015 kr 12,463 kr 15,332 kr 18,691 kr 19,850 kr 10,181 kr 13,117 kr 16,566 kr 20,615 kr 25,361 kr 30,919 kr 23,030 kr 11,812 kr 15,218 kr 19,220 kr 23,918 kr 29,424 kr 35,872 kr 39,700 kr 20,362 kr 26,234 kr 33,133 kr 41,230 kr 50,723 kr 61,837 kr

To sum up one can say that the results indicates that low-income earners preferring a low risk in their investments should not use IPS, while high-income earners preferring high risk investments should use IPS instead of directly investing on the OMX.

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5 Conclusion

The purpose of this thesis was to analyse whether individuals are better of saving in stocks for retirement using individual pension saving (IPS) or by investing directly on the Swedish stock exchange.

Considering the differences in return between IPS and OMX before payment, there exists a clear monetary advantage using IPS instead of OMX. The ability of tax deduction out-weighs the cost of tax on earnings on holdings which is charged on the IPS once a year. The advantage increases when taxes increase. An individual with income and state tax equal to 56.6% when saving gains the most using the IPS system.

Examining the differences in return after payment when tax rate equal 31.6% when saving and retrieving the payment, imply a monetary advantage for IPS in all cases when real rate of return is larger than 2%. A real return equal to or lower than 2% gives OMX an advan-tage compared to IPS. Therefore individuals gain from IPS, but only if real rate of return is larger than 2%. In the long-run the rate of return will most likely be larger than 2%, be-cause the average real rate of return in Sweden since 1900 has been 7.8%. Nevertheless there is a risk of saving money in IPS, especially for individuals paying only income taxes now and in the future. This is due to the fact that future tax rates are uncertain. The in-come tax paid today can be lower than the inin-come tax paid in the future. This implies that one will loose on saving money within the IPS system. If the opposite will occur, the indi-vidual will gain. Furthermore it indicates that low-income earners should not use the IPS system if they want to invest in low risk securities.

If the tax rate is 51.6% or 56.6% when saving and 31.6% when retrieving payment, IPS have a clear monetary advantage in all cases examined, compared to OMX. As the tax rate increases when saving, the benefit from using IPS increases. For individuals that pay both income and state tax before saving and will only have an income tax when going into re-tirement, will gain the most of using the IPS system. This implies that an increase in taxes on income benefits saving in IPS. The possibility to deduct has a large impact on return compared to OMX, where the money is taxed. If an individual wants to save money pri-vately for retirement i.e. making a long-term investment, the IPS system clearly outper-forms investments directly on the stock exchange. This also indicates that high-income earners should use IPS instead of OMX if they prefer to invest in high risk securities. In the scenario where the tax rate is 51.6% when saving and retrieving the money will benefit the IPS user in all cases when real rate of return is larger than 2%. If it is equal or lower than 2% implies that OMX is more beneficial than IPS. In this scenario the IPS will most certainly outperform OMX, due to the fact that real rate of return has been 7.8% sin-ce 1900.

If the tax rate is 56.6% when saving and retrieving payment, IPS has a monetary advantage in all cases when the duration period is 15 years or longer and the real rate of return is lar-ger than 2%. For the same duration periods and a real return equal or below 2%, OMX has an advantage compared to IPS. Furthermore, if duration equals 10 years real rate of return equal or is less than 4% and the saving period equals or is less than 5 years gives OMX an advantage compared to IPS. For same duration period, saving period larger than 5 years and a real return larger than 2% will give IPS an advantage and if real rate of return is equal to or lower than 2% a disadvantage. Finally, if the duration period is 5 years, real rate of re-turn equals to or is lower than 4% and saving years equals to or is less than 11 years will give a monetary advantage for OMX compared to IPS. If saving years increase this implies

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that when the real rate of return is larger than 2%, then IPS outperforms OMX and if it is equal to or less than 2%, then OMX outperforms IPS. If an individual’s purpose is to save money for retirement, IPS system should certainly be used instead of OMX, when having yearly income above 306,000 SEK (2006) i.e. paying income and state tax when saving and assuming to have income tax when receiving payment. If an individual has an income be-low 306,000 SEK and expects to stay in the income tax category, then any gain from the IPS system is very uncertain.

If an individual instead is saving for precautionary reasons, i.e. buffer stock saving, then he or she should save money without using IPS, because of the accessibility of money. It is not locked in until 55 years of age and therefore more accessible if unforeseen events ap-pear. As one also can observe from the analysis, having the highest tax rate before and after saving imply that OMX outperform IPS when duration is 5 years and saving period is 11 years or less and the real rate of return is 4% or less. This also indicates that one should use OMX.

To sum up one can say that the results indicates that low-income earners preferring a low risk in their investments should not use IPS, while high-income earners preferring high risk investments should use IPS instead of directly investing on the OMX. Furthermore the negative feature of IPS is the locked up capital until the age of 55 and also that there exist uncertainty about one’s life length. The positive feature is the long-run monetary gain using IPS instead of OMX for those having income above 306,000 SEK this year. The positive feature of OMX is the accessibility of the savings. The negative feature is that no tax de-duction can be made when saving directly on the OMX. Nevertheless one has to remember that long-run projections about future income are a difficult task to achieve, because of the uncertainty about changes in laws and regulations in the future.

5.1 Suggestions for Future Research

Saving privately for retirement is an area where one has vast possibilities to enter deeper into. Here are some possible suggestions for future research within the subject:

• How will administration and commission costs affect the result? • What are the monetary differences between IPS and Capital Insurance?

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References

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Internet References

Konsumenternas Bank-& Försäkringsbyrå (2006). Individuellt Pensionssparande (IPS). Retrie-ved 2006-04-17 from http://www.konsumentbankbyran.se/frames.asp

Konsumenternas försäkringsbyrå (2006). Sparande i försäkring. Retrieved 2006-04-17 from http://www.konsumenternasforsakringsbyra.se/frames.asp?url=/artikel/article.asp?_tp_ar ticle_id=83&avd=ART_FAK&menu=ART_FAK

London Business School (2006). ABN AMRO Global Investment Returns Yearbook 2006.

Re-trieved 2006-05-25 from

http://forum.london.edu/lbspress.nsf/AllDocs/84B992DBA8A0FE5A802571100063F24 F/$File/06-07+GIRY+2006-1.pdf

Skatteverket (2006). Svar på vanliga frågor. Retrieved 2006-04-17 from http://www.skatteverket.se/meny/svarpafragor/fragorochsvar.106.39f16f103821c58f6800 011972.html

Statistics Sweden (2006). Sparbarometern-Hushållens ställning och transaction. Retrieved

2006-05-15 from

http://www.scb.se/statistik/FM/FM0105/2006k01/Finansinspektionen06KV1.xls

Statistics Sweden (2006). Folkmängd efter alder och kön 2005-2050. Retrieved 2006-05-24 from http://www.ssd.scb.se/databaser/makro/SubTable.asp?yp=tansss&xu=C9233001&omrad ekod=BE&huvudtabell=BefolkprognRev4&omradetext=Befolkning&tabelltext=Folkm%

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E4ngd+efter+%E5lder+och+k%F6n%2E++%C5r+2005%2D2050&preskat=O&prodid =BE0401&starttid=2004&stopptid=2050&Fromwhere=M&lang=1&langdb=1

Statistics Sweden (2006). Privat pensionssparande 2004. Retrieved 2006-05-24 from http://www.scb.se/templates/tableOrChart____157666.asp

The Swedish National Debt Office (2006). Statslåneräntor 2004. Retrieved 2006-05-15 from www.rgk.se