The property vs pension debate has been going for an ice age. Can Sarah Coles, personal finance analyst at Hargreaves Lansdown, finally settle the argument?
The property vs. pensions debate has been raging longer than the chicken and egg controversy.
For those involved in the pensions industry, it’s depressing that this debate is still going – especially since most experts feel that pensions have been the resounding winner every time it has come up.
So when Andy Haldane, chief economist of the Bank of England, weighed in on the side of property back in August, they simply sighed, dusted off their watertight arguments, and re-entered the fray.
This article is part of a wider series on investing, covering all areas from stocks and shares to buy-to-let, peer-to-peer and alternative investments. Click here to view the full guide.
Question of risk
Part of the frustration lies in the fact that regardless of what anyone says, people feel pensions are risky. As Patrick Connolly, a chartered financial planner with Chase De Vere points out:
“People don’t trust pensions. When they read news stories about pensions they are always negative.
Even when they are not issues that affect them personally – such as stories about BHS pensions – they put people off investing in a personal pension. By contrast, when people read about property, for decades the stories have been positive, and about price rises.”
He points out that they feel they can trust bricks and mortar, because they can see the physical manifestation of their investment, which feels more solid than a number on a statement.
The fundamental lack of trust in financial services leads people to suspect that because they can’t hold it in their hand, at any moment, their pension could somehow be destroyed ‘by the banks’.
Of course, in reality, pensions are generally a far safer bet than property.
When you invest in a pension, your money goes into a number of different investments within the overall pension wrapper. These will tend to include equities – including businesses of varying sizes all around the world. They will also include corporate bonds, Government bonds and commercial property – among any number of other things.
Your money is spread far and wide, which means that if a particular company disappoints, an asset class struggles, or a geographic region suffers, the other investments will help balance out the overall pension investments, and offset your losses.
The one area where it won’t invest is domestic property, which is a good idea given that so many people have already invested in their own home, so have a major slice of their investment portfolio exposed to that asset class already.
Risk is also limited within a pension by the fact that you are only investing money you have – so you cannot lose more than you invest. By contrast, people borrow to buy property, which will magnify their return on their investment in the good times, but in the bad times, they leave them languishing in negative equity.
The reason why so many people fail to see the risk in property investment is purely psychological. We prefer property emotionally because we can see and feel it.
We also suffer from ‘home bias’, where we prefer investments that are close to home, because we think we understand them. In reality, we don’t understand property as an investment at all. Not even the property gurus know what’s going to happen to the market next.
Pensions have admittedly done themselves few favours by being the subject of a number of scandals over the years. For pension professionals, building trust in pensions is an uphill struggle.
However, with each scandal has come new protections, legislation and market development, so that new pensions have charge caps and low fees, the money is held in trusts, and they are regulated by the Financial Conduct Authority: pensions have never had so many safeguards.
Designed for retirement
Legislation has helped refine pensions so they are now ideally suited to fund retirement.
As Tom McPhail, head of pensions research at Hargreaves Lansdown, says: “They are easily accessible: you can invest for as little as £20 a month.” You have flexibility over contributions too, so you can start small, build up, and vary contributions any time you need to.
You have flexibility over your investment choices too, and can decide exactly where your money is invested – and change at any time.
What’s more, starting a pension is incredibly straightforward. If you can invest through a workplace pension, all you have to do is let yourself be automatically enrolled into the scheme – and take no action at all.
In a workplace scheme, there’s also the opportunity to have your employer contribute to your pension.
There’s a bare minimum available through auto-enrolment, but in many cases if you choose to pay in additional salary, your employer will offer some sort of matching arrangement.
Withdrawing the cash is straightforward too.
Once you are over the age of 55, McPhail points out that you can withdraw whatever you want, with a week’s notice.
After the 25% tax-free lump sum, you will have to pay tax at your marginal rate, but you can take it as a lump sum, draw some down, leave it all invested, or turn some or all of it into an income through an annuity – whatever you decide suits you best.
Compare this to a property, where you have to take all or nothing (or pay to remortgage), and even then it can take up to six months to liquidate your investment. If you pick the wrong time, the property may struggle to sell at the kind of sum you were hoping for, thereby crystalising your loses.
Pensions are also low cost.
The charges are capped, which means in newer schemes you are not going to lose enormous chunks of value through charges. Compare this to property, which costs a fortune to buy – including everything from solicitor’s fees to surveys, and mortgage company fees to Stamp Duty.
On top of the purchase price, you have to factor in the cost of renting it out, the maintenance and management of the property – and covering any void periods when the property is empty or tenants refuse to pay. This isn’t just expensive, it’s also an enormous hassle – and that isn’t necessarily something you factored into your retirement plans.
On the cost side, pensions are also designed to be tax efficient.
As Connolly explains: “When you initially invest, you get tax relief at your marginal rate. While your money is in a pension you effectively get tax-free growth, and then when you come to withdraw money you get 25% of it as a tax-free lump sum.
The rest is taxed at your marginal rate, but there’s an enormous amount of flexibility over how and when you take it, so you can time withdrawals to manage your tax liability.” If you die with money still invested in your pension you can pass it to your family free of Inheritance Tax.
Compare this to an investment property, where there’s not just Stamp Duty when you buy, but since April there has been an additional 3% loading on any second or additional properties. And from 2017, changes will be phased in that mean buy-to-let investors will not be able to offset their mortgage interest against tax any more either.
Then when you come to sell the property, there’s Capital Gains Tax to pay on any gains in value. And if you die before you get around to selling, then you will have IHT to pay.
Simplistic calculations of the gains you can make by investing in property often fail to take these costs into account. In an effort to make things clearer, Tilney Bestinvest provided two examples.
In the first, a 65-year-old man drew out his entire £150,000 pension fund as a lump sum in order to buy an investment property, and in the second he drew lump sums from his pension as income.
It’s important to accept that it’s possible to draw up an example to prove almost any point, but in this particular case, the man who left his pension invested ended up much better off – because of the costs involved in property investment.
The man who withdrew all his pension pot ended up with a massive tax bill – and cash of just £107,117. He then spent £2,117 on buying costs, and got a property worth £105,000. This produced rental income of £5,040 a year.
Tilney Bestinvest then assumed he died at the age of 70. By then, the property was worth £120,000, but after Inheritance Tax he passed on just £72,000.
By contrast, the man who left it all in a pension, and drew £5,040 a year (assuming the pot continued to grow 4% a year) had £149,000 in the pot when he died, which could either be passed on tax-free – or taxed at the recipient’s marginal rate of interest.
For those who argue that instead of investing in a pension at all, people should put it all in a property from day one, Finalytiq has crunched the numbers on that too. It went back to 1991, and assumed people either bought a property or invested in a pension.
The property purchasers spent £55,000, and made average monthly mortgage payments of £288. After 25 years the property would be worth £205,944. However, the profit after mortgage interest and extra costs of buying, selling and running the property would be £78,317.
Compare that to someone who started paying into pension in 1991. Their average monthly payments would be £320, which would leave them with a pension worth £168,663. Their profit after contributions and charges would be £103,244
Why are we still arguing about this?
It seems like a foregone conclusion that pensions are superior, but the reason we’re still having this debate is because there are plenty of people for whom property has proven the best investment they ever made.
Going back to the comments from Haldane that kicked off this argument again, he said that the best way to save for retirement “ought to be a pension”, but that in his case: “it’s almost certainly property.”
It therefore pays to take a bit of time looking at performance. As Connolly points out, investors look back at overall averages for the decades, and see relentless price rises.
This overlooks the fact that you are not buying an average property, or a basket of properties that average each other out: you are making a one-way bet on a single property, which is subject to unpredictable local forces.
Investors also assign too much value to recent performance, and assume price rises will continue at this remarkable pace, rather than looking at the long-term picture, and remembering that prices can fall as well as rise.
Likewise, pension investments are unlikely to continue on an uninterrupted march skywards.
Connolly says “There is a real possibility that equities will be volatile, and there’s always a possibility that values will fall, but if you are investing regular premiums, then this is ideal, because if you have a long-term perspective, you want to buy in when the assets are cheap, so when they rise in future, you see the value of your pension rise.”
McPhail agrees, adding: “There are no guarantees on any investment, but history tells us that over the long term, investing in a basket of equities will see your portfolio increase in value.”
There’s a reason why pensions win the property vs. pensions debate every time, and there’s good news for those who are tired of having this debate altogether. Over time, it is becoming increasingly irrelevant.
The price of property, the cost of living, and the weight of student debts means that young people are struggling to afford a property to live in – let alone a second one as an investment.
Young people will count themselves lucky if they have £20 a month left over, and the only sensible way to invest it for retirement will be a pension.
For those who want to learn more about retirement planning, read our comprehensive guide to pensions.
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