Income tax on PGBL and VGBL pension plans: analysis of progressive and regressive forms of taxation.
| Autor | Martins, Fabio Garrido Leal |
1 Introduction
In several countries studied by the World Bank (Holzmann et al., 2005), the main incentive to voluntarily pay into private pension plans compared to other traditional investments is that they are tax-favored arrangements. This is the case in Brazil, especially for supplementary private pension systems, which have gained an increasingly relevant role in the economy, accumulating BRL 956.9 billion in assets at the end of 2019. According to the National Federation of Private Pensions and Life (FenaPrevi), there are 13.5 million policyholders in the country (15% of the employed population). The most popular plans are the Plano Gerador de Beneficio Livre (PGBL) and Vida Gerador de Beneficio Livre (VGBL)--which will be explained throughout this paper. In 2019, these plans represented 8.5% (PGBL) and 90.8% (VGBL) of the total amount of funding by contributions or premiums (FenaPrevi, 2020).
These two products are technically distinct and adopt different tax treatments, but they offer the same specially constituted investment funds and the same kind of annuities. The PGBL was created in 1998 and offers the incentive of deductible payments up to 12% of taxable income at the time of contributions. In practice, there is a tax deferral until withdrawal or retirement. The VGBL is a life insurance plan with survival coverage, created in 2002. Contributions are not deductible, but income tax is applied on revenues. As occurs with the PGBL, income tax is postponed until withdrawal or retirement.
The Brazilian government modified the tax legislation in 2005 to encourage pension savings by offering a new option for exclusive and regressive taxation over time for such plans. The new legislation established the possibility of applying decreasing income tax rates, from 35% to 10%, according to the weighted average accumulation term. However, policyholders have to definitively decide on the form of taxation when they start paying into the plan. If they decide to be subject to regressive taxation, policyholders may choose to replace the traditional progressive taxation that applies increasing marginal rates of up to 27.5% according to the revenue bracket. Authors such as Saad and Ribeiro (2011) and, recently, Martins and Campani (2019), have pointed out a gap in studies investigating the choice between progressive and regressive forms of taxation. Therefore, a relevant line of research emerges from the opportunity to optimize taxation, maximize net wealth, and add gains to the amounts received from retirement benefits.
This study's general objective is to evaluate the decision between the two pension plans (PGBL and VGBL) and the form of taxation--the traditional progressive form or the alternative regressive method. It is a complex and dynamic problem involving long-term cash flow projections, influenced by several interrelated variables, such as management and loading fees, the life table, and other parameters used in pension plans, in addition to the individual's taxable income, savings, and deductible expenses. Issues such as the annual correction of the progressive income tax table, macroeconomic scenarios for inflation, and basic economic interest rates are also fundamental. Oliveira, Freitas, Testa, and Luciano (2002) analyzed the tools available on financial institutions' websites to support the decision regarding paying into pension plans, finding that such instruments do not consider all variables, especially inflation. We have identified that this scenario has not changed, even after many years. The constant currency premise is a limitation in the research and a simplification of the model, which distorts long-term decision analyses (Alvares, 2001; Souza & Kliemann Neto, 2012), mainly because income tax considers not only the real interest rate but also monetary corrections for inflation when calculating taxable income. This study is relevant in this sense. It carries out sensitivity analyses and produces original insights on this issue based on nominal cash flows and seeks to understand their effects on tax levels.
Some authors have already addressed this theme (Motta & Santoro, 2003; Lima, 2006; Coelho & Camargos, 2012) by comparing the profitability of different pension plans before tax collection. Recently, two articles delved into the question of income tax incentives. Varga (2018) theoretically demonstrated and analytically measured that, especially in a high-interest environment, the PGBL or VGBL plans represent a better alternative to traditional investments in non-pension funds. Campani and Costa (2018) carried out a sensitivity analysis of real interest and management fees, concluding that the PGBL plan, and to a lesser extent the VGBL plan, have a greater advantage compared to traditional fixed-income funds in cases where the management fees of pension funds are no more than 0.5% higher than the fees charged by non-pension funds, a difference that currently corresponds to an average of 0.25%, according to Varga (2018). The authors of both studies suggested a preference for fixed-income funds with scheduled withdrawals, suggesting avoiding exercising the option for a retirement annuity. Saad and Ribeiro (2011) presented a theoretical model to assess liabilities and financial risks related to PGBL and VGBL retirement annuity as a call option. Melo and Melo (2009) calculated through micro-simulation that the actuarial annuity for lifetime retirement can have a positive net present value if postponed for over 70-year-olds since favorable parameters are in place (the life table and a real interest rate of 3% in the benefits phase or 50% surplus reversal). Based on our interpretation of these authors' findings and the information obtained from the field research of Campani, Costa, Martins, and Azambuja (2020), it can be stated that these conditions are not commonly offered in the Brazilian market.
We used an innovative approach when calculating actuarial present value gross and net of tax for nominal cash flows, applied to the objective function that minimizes the average effective income tax rate, according to the definition by Fullerton (1984). Three specific objectives are defined in response to the following questions: what variables influence the taxation of supplementary private pension systems in Brazil? What is the best pension plan to minimize income tax, considering the PGBL and VGBL and progressive and regressive forms of taxation? How can one save money to maximize wealth net of tax?
This study contributes by guiding decision making when choosing a form of taxation, leading to an increase in policyholders' net income from supplementary pension plans. As mentioned before, pension savings are attractive due to tax incentives. This favors the supplementary pensions sector, which accounts for the largest voluntary domestic savings instruments in Brazil and the world, and is essential to creating an environment of economic growth in a country.
2 Literature Review
Individual decisions to not form sufficient savings can burden the government's welfare responsibilities. To alleviate this negative externality, the development of tax incentive policies such as those favoring voluntary private pension systems is common practice (Harvey & Gayer, 2013). In 1853, the United Kingdom government was a pioneer in reducing social security spending (Cockerell & Green, 1976) by offering tax incentives to private pension plans/funds. It was followed by practically all European countries.
Barr and Diamond (2009) showed that several countries adopt incentives that generate regressivity in income distribution. In view of these findings, the authors suggested propositions to be observed by the different pension systems, public and private. If the incentive is applied in the income range that pays the highest rates, then the reduction in income tax, which is traditionally progressive, will result in regressive taxation. A number of studies, such as those conducted in Spain (Anton, 2007) and Ireland (Collins & Hughes, 2017), analyze and measure the effect of incentives on the distributiveness of current taxation given particular alternatives, examining the voluntary pension plans that supplement compulsory social security.
According to Disney and Whitehouse's (1999) taxonomy, taxes on pension plans may be levied, simultaneously or not, on the contribution (inflows to the fund), on the revenues obtained from the investments of pension funds (interest on the accumulated fund), and on withdrawals/benefits (outflows from the fund). Countries adopt different formats when collecting or exempting pension plans, whether in cash inflows, accumulated resources, or withdrawals, as identified for European countries by Holzmann and Guven (2009). In any case, whatever the type of taxation, as a rule, there will be a tax incentive for long-term pension savings when compared to the equivalent modalities of traditional investments.
In Sweden and Italy, pension savings are exempt from taxes only in the contribution period, and tax is levied both on revenues from funds and withdrawals or benefits paid. In Germany, Spain, Estonia, France, the Netherlands, the UK, and Ireland, only withdrawals and benefits are exempt (Anton, 2007; Sutcliffe, 2016; Collins & Hughes, 2017). In the UK, for example, 25% of the withdrawal amount or 25% of retirement income is exempt, but the exemptions range widely between countries. For example, in Austria it is 75% and in the United States it is 15% (Disney & Whitehouse, 1999). Different rates are also applied above the exemption brackets. Therefore, taxation can have multiple formats.
Sutcliffe (2016) shows that TEE (taxed contributions--exempt fund income--exempt benefits) collection targets workers, and since most have higher incomes than when they retire, the treatment generates more revenue for the government. On the other hand, if the tax is levied only on retirees, the savings...
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