2. Institutional background

Switzerland's pension system is built on three pillars. Thereby, the first and the second pillars constitute the core and account for the bulk of retirement income, whereas the third pillar is a voluntary, tax favored private pension savings scheme. The first pillar is a pay-as-you-go universal system which aims to provide a subsistence level of income to all retirees. The benefits depend on the amount of income earned during one's work life as well as the number of years contributed to the work force. The minimum is CHF 1,175 per month and the maximum CHF 2,350 per month (as of 2015).Footnote ² The statutory retirement age is 65 for men and 64 for women.

The second pillar, which is the focus of our analysis, is a fully funded occupational pension scheme, mandatory for all employees whose annual income exceeds a pre-defined threshold (CHF 24,675 in 2015). Its goal is to maintain pre-retirement living standards. An employer can choose from different organizational structures for his occupational pension plan. These range from setting up a completely autonomous pension fund to outsourcing the scheme entirely to an insurance company. The latter is relatively common – particularly for small- and medium-sized enterprises (SMEs). Occupational pension plans are notionally set as defined contributions, but carry extensive guarantees.

The three pillars are complemented by means-tested supplemental benefits in case total income is not enough to cover basic needs. Means-tested benefits create an incentive to cash out second-pillar pension wealth because they guarantee a minimum income at retirement and thus act as an implicit insurance against financial consequences of longevity.Footnote ³

At retirement, workers have the option to withdraw the accumulated second-pillar retirement capital as a monthly life-long annuity, a lump sum, or a mix of the two options.Footnote ⁴ Annuities are strictly proportional to accumulated retirement assets: second-pillar pension wealth W is translated into a yearly nominal annuity A using the conversion rate γ, hence A = γW. The conversion rate varies with retirement age and gender (see Table A2 in the Appendix). The law stipulates a minimum conversion rate for the mandatory part, which is currently 6.8%.Footnote ⁵ The annuity also entails benefits for dependent children and survivor benefits under certain conditions.

The accumulation and decumulation phases of occupational pensions are organized by the same provider. While it is possible to cash out the accumulated balances to buy an annuity in the unregulated market, such a strategy would never be optimal as the conversion rates (γ) in unregulated markets are well below conversion rates in the highly regulated second pillar.

If the annuity is chosen, the resulting annual income stream from pension wealth, A, is taxed like ordinary income in addition to any other income, in particular, income from the first pillar. The lump sum, on the other hand, is subject to a special, one-off tax applied to the full amount of pension wealth cashed out, disregarding any income or any other form of wealth.Footnote ⁶ If the annuity and the lump sum choice are combined, both taxes are applied separately to the amount withdrawn as either option.

Like ordinary income and wealth, annuities and lump sums are taxed at three levels in Switzerland: at the federal, at the cantonal, and at the municipality levels.Footnote ⁷

3. Calculating taxes on annuity and lump sum

We impute taxes since we do not observe the amount of tax paid by individuals after retirement in our data. To this end, we first impute the total tax liability for any amount of pension wealth and annuity income. Second, we apply the tax imputation model to our data.

Using information on tax schedules from the tax administrations of all 26 Swiss cantons, we first compute the basic tax which is defined by the cantons and determines progressivity of the tax schedule. Our computation for the basic tax includes tax deductions and accounts for the fact that the basic tax differs according to marital status. While there are large differences in tax progressivity across cantons, there are none between municipalities within each canton.

We then calculate the total canton and municipality tax load by multiplying the basic tax with the cantonal and municipality tax multipliers.Footnote ⁸ Contrary to tax progressivity, there are differences in tax multipliers between municipalities within one canton (but they do not differ by marital status). As there is mandatory tax filing each year for the majority of individuals,Footnote ⁹ individuals are usually well aware of the tax loads in their own municipality.Footnote ¹⁰

We use our imputation model on hypothetical datasets with observations from each municipality and different levels of pension wealth. Figures 1–4 illustrate substantial differences in taxes for both the annuity and the lump sum for both a moderate and a high pension wealth: the total tax liability on the lump sum of CHF 200,000 (CHF 600,000) ranges from about CHF 4,000 to over CHF 17,000 (CHF 18,000 to over CHF 63,000) and the total tax liability on the corresponding annuities (an annual income of about CHF 13,600 and CHF 40,800, respectively) ranges from CHF 0 to over CHF 2,000 (CHF 0 to over CHF 10,000). The main driver of these differences in tax loads are differences between cantons, not differences between municipalities within the same canton. While some municipalities have high (or low) taxes on both the annuity and the lump sum, others levy a high tax on the lump sum but only a moderate tax on the annuity, and vice versa.

Figure 1. Tax load on lump sum of CHF 200,000 (married individuals).

Figure 2. Tax load on annuity with pension wealth of CHF 200,000 converted to annual income of 13,600 (married individuals).

Figure 3. Tax load on lump sum of CHF 600,000 for married individuals.

Figure 4. Tax load on annuity with pension wealth of CHF 600,000 converted to annual income of 40,800 (married individuals).

To allow for a precise comparison of the tax burdens for the two pay-out options, we would have to compute the present values of tax load on the remaining lifetime for the annuity. We refrain from doing so as the tax load is roughly proportional to the period tax expense. Some factors for differences in the present value of future tax loads of the annuity, such as marital status and gender, are taken care of by covariates.

Taxes may change slightly over time as municipalities can adjust the municipality tax multiplier to increase or decrease their tax revenues. Cantonal taxes change in a more sluggish fashion since more parties and negotiations are involved. Five of the 26 cantons changed the basic tax calculation for the lump sum during the time period under consideration (Bern, Uri, Glarus, Appenzell Ausserrhoden, and Graubünden); however, these changes did not translate into large differences in tax liabilities. While we take into account these changes in our tax calculation model, we do not exploit changes over time explicitly.

Several cantonsFootnote ¹¹ introduced tax-related policy changes at a cantonal level in the time period under consideration, following one or more cantonal ballots. However, none of these changes were targeted at retirees.Footnote ¹²

Applying our tax imputation model to the data, we can impute the tax on the lump sum from gross pension wealth directly. However, to calculate the tax on the annuity, we first need to calculate the annual income stream after retirement by applying applicable conversion rates to pension wealth (see Table A2 in the Appendix) and add income from the first pillar.Footnote ¹³ Note that to estimate the effects of taxation on the choice between annuity and lump sum (see Section 5), we calculate both taxes for all individuals in our dataset, irrespective of their choice.

4. Data and descriptive statistics

We use administrative records from a large Swiss insurance company which provides pension plans to SMEs in the private sector. Ninety nine percent of Swiss companies are SMEs and they provide about two-thirds of work places in Switzerland (BFS, 2012). Most importantly, the data contain information on retirement choice, i.e., taking the annuity or the lump sum, or a combination of the two. From this information, the outcome variable, the annuity rate is created: the annuity rate is the amount of pension wealth withdrawn as annuity divided by total pension wealth.

The dataset further contains the following individual characteristics: date of retirement (date), age at retirement (age), gender (sharefemale), marital status (married), total second-pillar pension wealth at time of retirement (wealth), income in the year before retirement (income),Footnote ¹⁴ whether the individual receives a disability insurance (disability), and whether individuals have ever withdrawn some money from their second pillar to finance the purchase of a house (WEF, from the German ‘Wohneigentumsförderung’). We further know in which sector (defined by so-called NOGA codes) the individual worked prior to retirement (NOGA). We exclude individuals who receive full disability insurance because their choice to take the lump sum is severely restricted (descriptive statistics for the full sample are given in the Appendix in Table A1). Table 1 provides summary statistics for the observations which are used for the analysis.

Table 1. Descriptive statistics

^a Annuity after retirement: only for individuals who receive an annuity.

^b Fraction annuitized: only for individuals who annuitize part of their pension wealth.

^c Ratio: only for individuals with tax on lump sum > 0.

Our data are a fairly representative sample of the Swiss retirement age population and correspond closely to other papers which have used data from Swiss pension funds: the average annuity rate is almost equivalent to the rate of 0.443 in Bütler et al. (Reference Bütler, Staubli and Zito2013). Average age at retirement is only slightly higher than that in Bütler et al. (Reference Bütler, Staubli and Zito2013) and Bütler and Teppa (Reference Bütler and Teppa2007) where the average age is 63.9 years and 61.75 years, respectively, and remains stable over time (see Figure B1 in the Appendix). A lower share of women in this dataset corresponds roughly to the national average of second-pillar recipients, which is 0.41 (BFS, 2013).Footnote ¹⁵

For every individual, we first calculate the (gross) present value of an annuity, i.e., the present value of an annual income stream of 1 after retirement, without taking into consideration taxation. The present value (PV) captures changes in the yield curve which represent investment opportunities if the lump sum is taken.Footnote ¹⁶

Figure 5 shows the (average) tax rate on the lump sum across the wealth distribution. The average tax rates are defined as the percentage of post-retirement wealth spent on taxes. It shows that the tax rate on the lump sum is higher for Zürich than for other cantons and increasing at different rates across cantons. Taxes differ by marital status and date of retirement for individuals with the same amount of pension wealth and also (to a much lesser degree) over time. Both become apparent in Figure 5 by the cloudiness of the figure: for the same level of wealth, tax rates differ between individuals within the same canton due to marital status and date of retirement.

Figure 5. Tax rate on lump sum across wealth (married and single individual).

5. Methodology

5.1 Ordinary least squares (OLS) regressions

In a first step, we explore the relationship between taxation and annuitization choice using OLS regressions. To this end, we run regressions of the annuity rate on three different tax measures: the (average) tax rate on the annuity, the (average) tax rate on the lump sum, and the ratio of the tax on the annuity to the tax on the lump sum.

The OLS regressions can be written as follows:

(1)$$Y_i = \beta _0 + \beta _1 \times Z_i + \beta _2 \times X_i + \eta _i$$

where Y _i is the annuity rate defined as follows:

(2)$$Y_i = \displaystyle{{{\rm Amount\;of\;pension\;wealth\;withdrawn\;as\;annuity}} \over {{\rm Total\;pension\;wealth}}}$$

Here, Z _i refers to our tax variables and X _i are control variables. The tax rate on the annuity and the tax rate on the lump sum are included in the same regression because they represent a trade-off between the two choices.Footnote ¹⁷ The regressions on the tax ratio are run separately to avoid collinearity. We control for the most important confounders, that is, we control for age, age squared, gender, marital status, the present value of the annuity, and the sector in which the individual has worked prior to retirement as all these factors have been shown to affect annuity choices (for the relationship between age, gender, marital status, and an annuity's value see, e.g., Bütler and Teppa (Reference Bütler and Teppa2007), and for the relationship between work sector and annuity choice see Bütler and Ramsden (Reference Bütler and Ramsden2015)).

We further control for pension wealth (which includes second-pillar contributions from all previous jobs) as the tax rate is a function of accumulated pension wealth, and wealth squared to capture non-linearities in wealth with regard to annuity demand. Time dummies are included in most regressions because we observe an increase in the annuity rate over time (see Bütler and Ramsden, Reference Bütler and Ramsden2015, for a discussion). We do not include canton fixed effects because this would eliminate an important source of variation in relative tax loads of the two drawdown options.Footnote ¹⁸

Variation in the tax rate can be considered exogenous as the tax rate does not affect second-pillar savings (although it might affect private savings). Individuals can optimize their tax load by choosing the most beneficial draw-down option (annuity, lump sum, or mix of the two), or by relocating to another canton with a more favorable tax rates. While the first decision is nearly free, moving to another canton takes a huge financial and non-financial hit. Indeed, based on recent research it can be assumed that the willingness to migrate is low among the elderly, in particular for lower and mid wealth individuals.Footnote ¹⁹ There is thus little concern that our results suffer from endogeneity bias due to individuals changing residence prior to retirement to take advantage of favorable tax conditions after making a choice between the annuity and the lump sum. Nevertheless, we use several strategies to address potential endogeneity issues such as selection effects into low-tax municipalities.

First, we exclude high-wealth individuals from the dataset as those are the ones which are likely to migrate to take advantage of lower taxes.Footnote ²⁰ This is primarily important for the regressions on the lump sum tax rate: since the tax on the annuity is the same as the tax on income, people who move for income tax reasons would have done so long before retirement. Moreover, excluding wealthy retirees circumvents the problem of a potentially different annuity demand for the very rich. Second, we control for income from last year of employment and withdrawal of pension wealth to finance owner-occupied housing (WEF): income before retirement might be an important determinant of residence, which in turn influences tax rates. Withdrawing pension wealth prior to retirement to finance the purchase of a house might directly affect the tax rate that individuals face at retirement. It reduces the amount of pension wealth in the second pillar, while owning a house makes moving more costly. Third, we control for cantonal debt per capita which proxies for tax expectations: individuals that live in a canton with high debt might expect tax rates to increase in the future, consequently choosing the lump sum over the annuity. We do not include this variable in all regressions as it is not available for 2014 and 2015, thus leading to a loss in observations.

The distribution of the outcome variable has two mass points at zero and one – since many individuals choose either only the lump sum or only the annuity. The resulting loss in efficiency can be taken care of by computing heteroskedasticity-robust standard errors. Results of a Breusch–Pagan test for heteroskedasticity support the use of heteroskedasticity-robust standard errors. We also re-estimate the regressions on the three different tax indicators with a Tobit estimation. The doubly censored Tobit model estimates both the likelihood and the intensity of annuitization by means of maximum likelihood methods and improves the estimates from the OLS regression which will be downward-biased for the slope coefficient and upward-biased for the intercept (Wooldridge, Reference Wooldridge2020).

5.2 Regression discontinuity design

Another way to assess whether individuals adjust their annuitization decision in light of taxes is to analyze whether there is strategic bunching at kinks in the tax-schedule within geographic entities. A mix between an annuity and a lump sum reduces the tax burden due to progressivity of both taxes. The relative gain over a polar option might be ample in cantons with large jumps in the marginal tax rate on the lump sum. In this case individuals can optimally choose the right combination of annuity and lump sum to end up in a more favorable lump sum tax bracket. For example, individuals in the canton of Basel Land with a pension wealth of CHF 410,000 pay around CHF 900 more in tax than individuals with a pension wealth of 400,000 if they choose the lump sum.Footnote ²¹ Individuals with a pension wealth of CHF 500,000 in the same canton may pay up to CHF 10,000 more in tax if they choose the lump sum, depending on the municipality of residence.

In all cantons, such a strategy pays off especially for individuals with high pension wealth. Figure B2 in the Appendix shows that for the three options, wealth is highest on average for individuals choosing the combination.

To gain insight into whether individuals strategically place themselves in a lower tax bracket, we exploit the fact that tax schemes of the lump sum create kinks in the marginal tax rate as a function of wealth, illustrated in Figure 6. We investigate the likelihood for choosing a combination of annuity and lump sum for wealth just above these kinks. For six cantons (Aargau, Basel Land, Basel Stadt, Bern, Fribourg, and Zürich, depicted in Figure 6), we have enough observations to allow an analysis of strategic bunching. However, Basel Stadt and Fribourg lack high lump sum thresholds at which marginal tax rates increase (the highest thresholds being at pension wealth 190,000 in Fribourg and 100,000 in Basel Stadt), and the canton of Zürich is characterized by small jumps in the lump sum MTR schedule (see Figure 6). Nevertheless, we estimate treatment effects for these three cantons as well.Footnote ²²

Figure 6. Marginal tax rate of lump sum across wealth.

We implement a regression discontinuity design where treatment – choosing a combination of annuity and lump sum – is a deterministic function of wealth and is defined as:

(3)$$T_i = \left\{{\matrix{ {1\quad {\rm if}\;w_i{\kern 1pt} {\rm \geqslant }{\kern 1pt} w_0} \cr {0\quad {\rm if}\;w_i < w_0} \cr } } \right.$$

where T _i denotes treatment, w _i denotes wealth, and w ₀ the wealth thresholds. The outcome variable Y _i is a binary indicator which equals 1 if an individual annuitizes part of his or her pension wealth, but not all of it, and zero otherwise. Hence, it excludes individuals who choose the full annuity. The treatment effect is estimated using a flexible parametric model within a narrow bandwidth (in terms of wealth), hence the regression formulation is:

(4)$$Y_i = \alpha _0 + \alpha _1T_i + \alpha _2W_i + \alpha _3W_iT_i + \varepsilon _i$$

The parameter α ₁ measures the average causal effect of being in a higher tax bracket on choosing the combination of annuity and lump sum at the assignment threshold W ₀. We include interaction variables W _iT _i between the assignment variable and the treatment dummy to control for the fact that the treatment may impact not only the intercept, but also the slope of the regression line.

Covariates are included as a robustness check. We do not include higher-order polynomials in the baseline estimation which would be justified when using observations far away from the cut-off for which different treatment effects are expected. Within a reasonably narrow wealth range, there is no reason to expect non-linearity between mean counterfactual outcomes and the running variable (see Jacob et al., Reference Jacob, Zhu, Somers and Bloom2012 for a discussion). Nevertheless, we perform a series of robustness checks including polynomial terms along with covariates and interaction terms. A summary of these robustness checks for the two highest tax thresholds for the canton of Bern can be found in the Appendix in Tables A10 and A11.

To provide unbiased impact estimates, the cut-point must be determined independently of the rating variable, i.e., the accumulated pension wealth must be exogenous. This is the case in our setting as it is nearly impossible for individuals in Swiss pension funds to manipulate their pension wealth: pension wealth is accumulated over the whole work life and it depends on individual decisions with regard to one's occupation (e.g., working part-time or full-time, or being employed or self-employed), the amount earned, marriage and divorce decisions, and above all the regulatory environment of the pension fund chosen by the employer. Graphical evidence for no sorting around the relevant thresholds for the cantons Aargau, Basel Land, and Bern is given in the Appendix in Figures B4–B6.