Dear investors,
Historically, how to support oneself in old age was a private matter. People supported themselves with their life savings or relied on their children to support them when they could no longer work. The first comprehensive public pension system was created in Germany in 1889, during the government of Otto von Bismarck, providing retirement benefits to workers over the age of 70 (later reduced to age 65 in 1916).
At the beginning of the 20th century, several countries followed the German example and created their own public pension programs. Brazil took its first step in 1923, with the Eloy Chaves Law, which created a fund called the Retirement and Pension Fund (CAP) for employees of railway companies. This structure was soon replicated by several other professional categories and the number of CAPs multiplied, each administered by an employer company and operating under the principle that the resources accumulated through contributions could be used exclusively for the payment of benefits.
In the 1930s, under the government of Getúlio Vargas, the CAPs of companies under the same professional category were consolidated into Retirement and Pension Institutes (IAPs) and the government became part of the arrangement, participating in the administration of the IAPs and, at times, also contributing to the fund as a way of subsidizing certain professional categories. In 1966, the IAPs were unified into a single entity called the National Social Security Institute (INPS), a direct precursor to the current National Social Security Institute (INSS). When the government began to act in the social security system, already through the IAPs, the principle that the resources of the social security funds could be used exclusively for the payment of benefits was abandoned. This was the seed of the social security problems that still exist today.
Where does the pension deficit come from?
The logic of a pension fund should be quite simple. Workers invest in the fund on a monthly basis, the value of these contributions is invested over time and the assets thus created are used to pay pensions. A reasonable rule is that the benefit is proportional to the years of contribution, except in exceptional cases that result in death or premature disability. In a very large group of people, there will be those who receive more and those who receive less than the result of their own contributions, but since the factors that determine who will be in each case are practically random, the homogenization of benefits is a simple mechanism for sharing and diluting life's risks.
A pension system created with these rules would have contributions much higher than benefits paid for many years, since those who retired soon after its creation contributed for a short time and will receive little, while those who joined the system while still young will have decades of contributions ahead of them before receiving their pension. This phase of wealth accumulation would only end when the youngest generation of contributors reached retirement age. If new contributors stopped joining the system, there would be no problem. The pension fund should have resources to pay until the last generation of retirees without depending on new contributions.
This was not the case with our social security system due to a public sector maxim: the government always finds a way to use the resources it has access to. The Vargas government itself, which created the IAPs, interpreted the purpose of these institutions as defending the long-term interests of their beneficiaries, which was not limited to paying pensions, but also involved promoting economic and social development. As a result, social security resources began to be used to finance infrastructure projects and other investments of political interest.
The crucial issue of how to finance the payment of pensions to beneficiaries was addressed based on the logic that pension funds would never run out, so that contributions from new generations would be sufficient to support the benefits of retirees, without the initial assets having to be fully preserved. In a simplified manner, the State decided that it could appropriate the contributions made by parents throughout their lives and use the contributions made by children to pay their parents' pensions.
There are a number of assumptions involved in judging how much money would need to be held in pension funds to be able to maintain pension payments in this way. For example, the population growth rate (how many children will support their parents' retirement) and the retirement age and average life expectancy (how many years parents will survive in retirement). Since adopting optimistic assumptions allowed the state to make more resources available for its own purposes, this was done.
The problem is not exclusively Brazilian. Several countries, including several developed countries, have adopted the same principle that pension fund resources could be used for other purposes and today have pension deficits caused by two major secular trends: the increase in life expectancy and the decrease in the average birth rate. In other words, fewer and fewer active workers are required to make contributions to finance the benefits of more and more retirees, knowing that when they themselves retire, it is very likely that they will receive less than they contributed.
The most correct way to correct the problem would be for the State itself to cover the pension deficit and honor the terms in force when the contributions were made, but any issue involving the government becomes complex. The current government is not the same one that made the decision to appropriate the pension funds and there are no surplus funds to make the necessary compensation. It would be necessary to cut other public spending or increase taxes. There is no elegant way out.
The path taken by practically all countries with problems of this nature was to reform the rules of the social security system. Brazil did this in 2019, with changes that increase the required contribution period and reduce the value of part of the benefits. It was a mitigating measure that does not solve the problem in the long term. The social security deficit still exists and continues to increase.
The solution is private pensions
As unfair as it may be to be forced to contribute to a social security system that has a high risk of not paying its benefits in full in the future, there is no way out for most Brazilians. Contributions to the INSS are compulsory at source, deducted directly from the monthly payments made to those who work under the CLT regime. The alternative is to save something in addition to the compulsory contributions to build up assets that can be maintained under your own control and guarantee sufficient resources for a comfortable retirement.
Recognizing the inadequacy of the public pension system, in 2001 the Brazilian government created the Supplementary Pension Scheme (RPC), an optional membership system that grants some tax benefits to those who create private pension plans. The available options are the famous PGBL and VGBL, both with the possibility of choosing between the progressive or regressive taxation regime. Details about each type of plan are available in several places, so we will focus only on the characteristics of the PGBL and VGBL that matter most and on the regressive taxation regime, which will be the most advantageous for the vast majority of our investors.
PGBL
The benefit of the PGBL is that you can invest up to 12% of your annual taxable income in pension funds and this amount will be exempt from income tax (IR) that would be charged in the year. On the other hand, the entire balance invested in these funds will be subject to income tax upon withdrawal. There are two relevant advantages to this arrangement.
The first is that the IR rate can be reduced from 27.5% to up to 10.0%, under the regressive taxation regime, as the rate falls over the period of permanence in the pension plan, as per the table below:
From the fourth year of investment onwards, the rate is already advantageous and, considering that the intention is to save for retirement, it is not difficult to reach the 10 years necessary to take advantage of the maximum reduction.
The second advantage is that, even if the income tax rate were the same, not paying the tax now and only paying it when withdrawing the investment (deferred income tax) brings a significant difference in return over long periods. In 20 years, the investment with deferred income tax would be worth around ~17% more than an investment with the same return, but with annual income tax payment. This is the same benefit that exists for investments in equity funds.
Combining the tax rate reduction and the IR deferral, the difference is huge. Let's simulate the case of someone who earns R$250,000/year and invests R$30,000 (12% of the annual salary) in a pension fund with an annual return of 15%. If the investment is redeemed after 20 years, its net value will be 44% higher than what an equal investment would be worth, but without the tax benefit of the PGBL.
Investment simulation in PGBL with regressive table
In short, for those who work under the CLT and have a salary in the upper range of the IR table, it is quite advantageous to invest in PGBL with a regressive taxation regime. If possible, up to the limit of 12% of the annual salary and for a period of more than 10 years.
VGBL
The tax benefit of the VGBL is only the reduction of the tax rate under the regressive taxation regime, from 15% applicable to capital gains to 10% as of the 10th year of investment. However, the VGBL has a useful feature for succession planning: in the event of the holder's death, the invested amount can be transferred to a designated beneficiary without going through the probate process and without charging ITCMD (from 2% to 8% of the estate, depending on the state of residence), since the VGBL works in the same way as life insurance.
There are two typical use cases for this VGBL mechanism: the first is when there is an expectation that the probate process will be lengthy and there are heirs who are unable to support themselves independently. The VGBL is a way to quickly transfer a portion of the estate to these heirs. The second case is when there is a desire to divide the inheritance differently than that provided for by law, because the VGBL is not included in the estate to be shared among the heirs. In fact, anyone can be named as a beneficiary of a VGBL plan, whether they are an heir or not.
What is the best strategy for investing in retirement?
As the Chinese saying goes, “The best time to plant a tree was 20 years ago. The second best time is now.” The sooner you start saving for retirement, the less you will need to invest, since the effect of compound interest increases exponentially over time. So, if you don’t already have a retirement investment strategy in place, you should start thinking about one as soon as possible.
There are two basic principles that arise from the nature of these investments: you should invest with the very long term in mind and there is no need for liquidity, since the idea is to only withdraw these resources when you retire. Thus, the goal is to seek the best possible rate of return over decades, while maintaining a good dose of prudence. Price volatility that is unrelated to the fundamentals of the invested assets matters little, since, over very long periods, these market fluctuations tend to cancel each other out and the return converges to how much the fundamentals have actually evolved. This mentality makes sense whenever there is no need to use the invested resources in the short term. The good principles for how to build wealth are the same regardless of the final purpose of using the accumulated capital.
This is the investment philosophy we adopt in our funds and we choose to invest in stocks because it is the asset class with the highest return over long periods, a point well illustrated by Jeremy Siegel, a professor at the University of Pennsylvania (Wharton School), who collected investment data in the United States over 220 years and compiled it in the graph below.
Comparison of returns between stocks, fixed income, gold and the dollar
Source: Stocks for the long run, 6th edition (Jeremy J. Siegel)
Some argue that this conclusion does not apply to Brazil, since the IBOV has had returns very similar to those of the CDI in recent decades, with much greater volatility. However, our market offers many opportunities for those who are willing to select the best companies on the stock exchange and invest in them during times of stress, when prices fall sharply. We have been doing this for over 11 years and the average return we have had since the founding of Ártica Long Term FIA until today has been 29.2% per year, equivalent to 314% of the CDI return in the same period.
Launch of Arctic Pension
Although our philosophy is well suited to pension investments, it was not possible to invest with us through PGBL or VGBL until now, as these plans require that investments be made only in funds created specifically to receive pension funds. However, we have something new.
We have just launched Ártica Previdência FIM, which went into operation last Friday (11/29). In it, we will follow the same investment strategy as our other funds (Ártica Long Term FIA and Ártica Polaris FIA), with two adaptations: the first is that pension funds cannot have more than 15% of the portfolio in a single stock, so Ártica Previdência will be a little more diversified; the second is that the new fund will not need to keep at least 67% of the capital always invested in stocks, a term that is required of stock funds to be exempt from the come-cotas tax. In other words, we will have flexibility to invest, in addition to the most advantageous tax regime in Brazil: IR rate on capital gains of up to 10% without come-cotas.
Ártica Previdência FIM is now available to BTG clients, along with Ártica Long Term and Ártica Polaris. Our funds are not publicly available on the product platform, so the first contribution must be made by requesting it from your BTG account advisor. After the first investment, the funds will appear in the bank's app and additional contributions can be made by yourself. If you have any questions, we are available to help on WhatsApp (11) 97891-7619.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
