Every country seems to have a different retirement system. In this article, I will explain how the system in The Netherlands works. Based on this system, I have to make certain choices regarding my (early) retirement. Below are the three pillars in the Dutch retirement system.
The Three Pillars of Retirement
Here in The Netherlands, there are three pillars to our retirement system. The first pillar is the government’s social security payment.
The second pillar is the retirement that you save for with or through your employer. This can be a defined benefits pension or a defined contributions retirement account.
The third pillar is everything you arrange yourself. Sometimes this can be a pre-tax retirement account, but usually it’s also after-tax savings, investments, or real estate.
Pillar One: AOW
The AOW (Algemene Ouderdomswet) is a government scheme that resembles a social security payout for people past a certain age. Everyone who has lived or worked in the country has built up rights to AOW.
During your working years you pay into the system through your income taxes, after your official retirement age (68 and counting…) you get a defined benefit for the rest of your life.
The AOW is designed to be enough to sustain a very modest and frugal lifestyle. Currently the net income from AOW is around € 1.100 when you’re single, or € 770 per person when you’re married or in an otherwise registered partnership.
This is not an income that you can live a luxury life with, however, it is guaranteed by the government as long as you’ve lived your entire life in The Netherlands. For every year that you don’t live or work in The Netherlands, your AOW will be cut by 2%.
Pillar Two: Employee Pension
The second pillar is the pillar where most people get the bulk of their retirement income from. In the past this would be a defined benefits pension, via your employer directly or negotiated via a labour union. These days, less and less employers offer defined benefits pensions. Instead, there are defined contribution plans that you and your employer can put money in. This money is then invested, and when you reach retirement age you buy a defined benefits income with this money.
These accounts are similar to the US 401k accounts, in that you can put money in pre-tax, and that your employer might contribute too. However, the amount of money you can put into a retirement account in The Netherlands is capped.
First of all, the maximum yearly gross salary over which you can contribute to your retirement income is about 105k euro. Anything over this salary doesn’t contribute to your maximum pre-tax retirement savings.
Second, from your gross salary you deduct the AOW franchise, which is in the order of 13k euro per year. Say your income is 50k per year, you can calculate your maximum retirement contributions by subtracting 13k from 50k, giving 37k.
The amount of money you can put in that year is a percentage of the retirement yielding income (in this case the 37k). This percentage is depending on your age bracket. For example, for the age bracket 20-24 this percentage is 3.5%, for 25-29 it’s 4.3%, for 60-64it.s 17.8%. The older you get, the more you can put into this retirement account.
Pillar Three: Individual Retirement Account
The third pillar in our retirement systems is what you can save yourself. This consists of two parts. In this pillar you could potentially save some pre-tax money, depending on how much you’ve put in your pillar two. Also, you can save post-tax.
The pre-tax option only works when you don’t save enough in pillar two to max out your retirement savings. This happens for example when you are allowed to put in 17.8% (at age 60-64) but you only put in 10% because that’s the employer’s choice. You are then allowed to save the difference (7.8%) in a personal pre-tax retirement account.
The second part is your after-tax savings. As always, you can put money in the bank, in an investment account, or buy rental properties that yield some income. When you retire, you can use this capital to pay for some of it.
The downside of saving for yourself is that you don’t get the tax benefits, since all of these investments are done with after-tax income. However, the positive side is that you can do whatever you want with this capital. The money in your pre-tax accounts is locked up until retirement, but in your post-tax accounts you are free to do all you want.
Optimise in Two, Save Extra in Three
The road to a great retirement, at least for employed individuals with an employer’s retirement account, is to optimise their second pillar and save extra in the third pillar.
At the moment I’m investigating how I can optimise my second pillar. Via my employer I put away 4% of my eligible salary (gross salary minus franchise) in a pre-tax account, which is invested in not so great funds. However, I believe there are better investment options within this account. I will definitely blog about this when I properly researched and made the switch.
Next to that, of course, I’m saving my after-tax money. Currently, I save about 35-40% of my after tax money, putting it in low cost ETFs. Also, every year I review whether I should contribute some money to a pre-tax account to make use of the entire fiscal space I have. Via my employer I only save 4% of my eligible salary, where I could do a little more than that. However, since the pre-tax accounts are locked away it is not clear to me whether I should invest more in them, given that I want to retire early.
How do you save for retirement? Do you max out your pre-tax options every year? Let me know in the comments!