Property vs Pension: Which is Better for Retirement?
The words ‘property’ and ‘pensions’ are almost constant factors in our lives from a very young age, in that everybody needs somewhere to live and everybody needs some kind of pension for when they retire. How we get there in each case is a very complex issue and very much down to our own financial circumstances. But nevertheless, the property or pension debate is an enduring discussion with lots of pros and cons to consider, in terms of which one will give you the best financial security in retirement.
Property is well established as an investment vehicle, whilst pensions have always been viewed as a necessity. But one can outperform the other, and there is an ongoing debate as to which is the more profitable route. Certainly, the route to retirement can involve some life-changing decisions in terms of how you manage a property investment or a pensions investment. So here we are going to study each area, assess the pros and cons and establish circumstances in which one may be more suitable than another, or where a combination of the two might be the best way forward.
Why a retirement nest egg is necessary
Everyone will receive a state pension when they retire, as long as they have been contributing tax and national insurance during their working life. However, this Government support is not usually sufficient to see us through our later years, and at the end of our working life we have earned the right to a comfortable standard of living in our retirement. We might also have to consider the cost of healthcare in our later years, and might not have dependents we can rely on for support, so we may wish to put some funds aside to contribute to this.
This means that planning for our retirement at an early stage of our lives is certainly beneficial. Paying into a pension fund on top of the expected income from the state pension has been the traditional way of doing this. But separate investment in property is also a well-established means by which a healthy nest egg can be accumulated. If we have been savvy, our regular outgoings should be considerably reduced in retirement, in line with the fact that we are likely to be earning a much reduced income from some sort of part-time career, if we are earning anything at all. So planning for our income in retirement is essential to ensure we have a standard of living that is comfortable, guaranteed and ongoing.
How to make money out of property investment
Generally speaking, when we talk about property investment in terms of making money for your retirement, we are not talking about your residential property. It is difficult to rely on that as an asset to see you through retirement, as you will always need somewhere to live. Yes, you could downsize your property in retirement and live off the proceeds, but it will take considerable skill and several market forces going your way for this to be sufficient. So when we are talking about property investment, we mean the buy-to-let (BTL) property market.
BTL investment is popular because there will always be a sizeable sector of people in society who can only afford to rent a property, rather than buy one. This is an established and very accessible market, because most people see it as a market that is understandable, relatively predictable and only needs a small investment to get into.
Another major factor is that income from the BTL market comes in two ways; rental income and capital growth. This means that BTL investment can help you with liquid cash – in some cases possibly providing a full-time career – as well as a hopefully accumulating asset to be cashed in when you retire. Rental yield is the term we use to refer to the regular income you receive from tenants. This can be expressed as a percentage and is calculated as the expected income over a 12 month period, divided by the costs of the investment over the same period, which includes mortgage repayments and maintenance/repair costs. A rental yield of around 7 or 8% is considered to be a good one. When entering the BTL market as a means to funding your retirement, however, you always need to have an exit strategy in mind. This means for every property you have in your portfolio, you need to plan ahead for the right time and circumstances in which to sell. This is all about timing, but you need to assess the possible scenarios and work out when your profits will be maximised by selling. This will be a good indicator as to whether individual properties are worth purchasing, as they could become a financial hindrance in later years, which could therefore become counter-productive to your retirement plans.
What pensions are most popular?
There are, generally-speaking, three types of pension product available to most people. The state pension we have talked about. On top of that, people are often offered a workplace pension, which increasingly is an obligatory element of taking a job with an employer. Here, you pay a percentage contribution into a ‘pension pot’ each month, and the employer matches this with a similar contribution. This is a very favourable way to build a pension nest egg, as the employer’s contribution is now a minimum of 3% due to the auto-enrolment system, and your own regular contribution is deducted automatically from your salary and is often almost forgotten about as a cost you have to make. A workplace pension will not be accessible until you reach 55 years of age, and you usually have no control over how the money is invested. A pensions manager appointed by your place of work will invest the money and it will hopefully grow based on those investments.
You can also choose to invest in a personal pension scheme. This could be on top of your workplace pension, or this could be your only means of growing a pension in addition to your state pension, for example if you are self-employed or have chosen to opt out of a workplace pension scheme. Here you can contribute a percentage of your earnings towards a pension fund that is invested in dividend-producing investments, such as a SIPPs (self-invested personal pension scheme) or a SSAS (small self-administered scheme), or a low-cost investment such as an ETF (exchange traded fund). These are usually tax-efficient schemes that provide a regular dividend, which can be saved in your pension fund and will hopefully grow in value for later life, on the basis of compound interest.
Property as a retirement investment
So when we are looking at investing in BTL property as a means of funding our retirement, what are the pros and cons of property vs pensions?
Pros of property investment:
Tangible asset - Property is a real, tangible asset that we can own and understand and we effectively have total control over what we do with it.
Faster and more predictable growth in value - Property can grow in value much faster than the rate of inflation, and with long term trends the manner in which a certain property in a certain area will increase in value is relatively predictable. This can work both ways of course, and historical trends can be an indicator as to how a property in one particular area may not increase above a certain level, and so may not represent a good long term investment. But certainly, there is plenty of data available on which we can base long term decisions.
Easy to sell - Property is a relatively liquid asset, in that we might earn more from it if we keep it long term, but we can cash in and sell it pretty quickly if we need the money.
Two income streams - In the BTL market you are earning money in two ways; through rental income which is immediately available cash, and through capital growth which is the long term contribution to your retirement.
Cons of property investment:
Dependent on market behaviour and decisions - Capital growth is very much dependent on how the market behaves and good decisions you have made in terms of location, the type of property and the timing of when you need to buy and sell. Costs you have faced relating to refurbishment or finding tenants can also eat into your profits to some extent.
Inheritance tax - Property is subject to inheritance tax upon your death, so whilst this might be a good investment for your retirement, it could become a cost to your dependents. Inheritance tax is payable at the basic rate up to £325,000 in the property value, then it rises to 40%.
Income may be insufficient - Rental income might be outweighed by the costs of being a landlord. These are numerous and considerable, and are very much the major consideration you need to make when weighing up whether to invest in an individual property. You might envisage a healthy rental income, but the rental yield % may be reduced by a number of costs, which therefore make it unviable or a financial burden if you have gone ahead with it. This may force you to sell the property, and make a loss and a negative dent in your pension fund.
Clampdown on landlords - Various regulatory changes and a tightening of tax restrictions in recent years have made the role of the landlord far less attractive. The Government may decide to continue this drive. Tax relief has been cut, stamp duty on second properties has been increased and landlords are required to have EPCs (Energy Performance Certificates) at a minimum rating of E, which can cost a lot of money to achieve.
Hassle - Being a landlord can be very time-consuming and involve a lot of hassle in finding tenants and managing them. You can also face void periods where you have no rental income. If the property does not match the type of tenant you are hoping to attract, there may be periods where you struggle to let the property.
Negative equity - You could end up in negative equity if a property doesn’t grow in value as you expect, or you are forced to sell it early and the amount you have left on the mortgage is exceeded by the amount you sell it for. This is why you should always plan to keep the property long term, if you can.
Costs - There are considerable costs involved in being a landlord; such as stamp duty, income tax on rental payments, maintenance and repair costs, and possible capital gains tax on your profits. This of course is in addition to your mortgage repayments.
Market knowledge - Short term blips in the market can force you to panic and sell, you are also subject to regional market forces. This means that a property in one area might be worth a lot less than an identical property in a more fashionable and up-and-coming area. This therefore needs a lot of market knowledge and sometimes a lot of good fortune.
Exit strategy - It can be difficult to plan an exit strategy when there are so many considerations and so many factors that can change in the meantime. So an investment at one stage might look very favourable, but that isn’t necessarily going to be the case in 25 years’ time when you are looking to sell.
Pensions as a retirement investment
In recent years there have been some high profile ‘scandals’ involving well-known companies, which have rocked people’s trust and confidence in pension schemes. But they still represent a good investment vehicle, and if you take professional advice then there are ways to manage this and mitigate, or guard against, any potential losses. Nevertheless, let’s look at the pros and cons of investing in pensions for your retirement.
Pros of pensions investment:
Tax efficient - Pension schemes can be very tax efficient. You currently receive a 20% tax relief on your contributions to a pension scheme on the basic rate, and 40% at a higher rate. You can also take 25% of your pension pot as a tax-free lump sum upon reaching the age of 55.
Inheritance tax exemption - Pensions are also exempt from inheritance tax, so any funds you have built up can be passed on to dependents upon your death, without them being taxed on it. However, this only applies to amounts left in the pension fund. If you have withdrawn an amount of money from the fund, this is classed as part of your estate and hence is subject to inheritance tax.
Passive investment - Investing in pensions is very much a more passive form of investment compared to the hands-on management required for BTL property investment. Even if you employ a letting agent to manage a property, there are far more decisions and actions to be made. With pension schemes there may be some management involved in choosing what to invest in and monitoring it, but you can employ someone to do this for you or choose a less-risky portfolio that doesn’t require much management. And with a workplace pension scheme the investment is done completely for you, so your involvement is 100% passive.
Flexible contributions - With a personal pension your contributions are flexible, so you can change the amount you contribute to what you can afford (either higher or lower). This needs to take into account the return you want or expect and whether your contributions will provide that, and also you should be aware that with a workplace pension, you don’t usually have this option and your payment amount will be fixed.
Diversification - You can introduce diversity into your pension fund portfolio to reduce the risk of your fund not performing. This is a well-established strategy for any form of investment and does protect you against one product under-performing, and means that the chances of the fund growing over the long term is considerably increased.
Compound interest - The simple rule of compound interest works in favour of your pension fund, in that the more you invest, the quicker the fund grows, if the mix of investments is right. This is not the case with property, in that capital growth is dictated by the market and what you paid for the property in the first place, so you may not get back what you paid in.
Protected - If you choose a pension plan with an organisation that is FCA-regulated, then your pension fund will be protected should that business go bust.
Cons of pensions investment:
Unpredictable - Some pensions investment markets are unpredictable and so past performance only gives you an idea of how they might perform, it is not a guarantee. This could make historical data on the property market more reliable.
No guarantee - You are not guaranteed a return on your investments if you choose the wrong products to invest in, and hence you may not get back what you put in.
Possible shortfall - If a pension plan has not grown sufficiently during your working life, you could face a shortfall during retirement and will need to find other ways – such as equity release for example – to fund your lifestyle. This could be costly and may leave dependents out of pocket also.
Costs - There are regular costs involved in running pension funds which can mount up, and whilst they might be relatively small they need to be taken into account. These can be transaction fees, platform fees or financial advice fees.
Income tax - When you have reached the age of 55, you will need to pay income tax on any amount of money you withdraw from your pension fund over the 25% tax-free threshold.
Pensionable age - You cannot access your pension fund until you reach the age of 55, and even then it may not be advisable to do so.
Product mix - It can be difficult to find the right mix of investments to match the regular contributions you are comfortable making, your appetite for risk, and the returns you wish to make. And of course with a workplace pension you get no say in this and therefore have no control over it anyway.
Property vs Pension: deciding what is right for you
As with most investment decisions, deciding on investment in property or pensions is very much dependent on individual circumstances, your appetite to taking risks and what your overall ambitions are. People who like an easy life, wish to have only a passive involvement in the investment and don’t want any day-to-day hassle, may prefer to invest in pensions rather than be a hands-on landlord. This would also attract a person who is perhaps more comfortable with taking an investment risk.
However, there are many pension products available, and with professional advice you should be able to find a suitable product to match your attitude to risk. Some people are happy to make regular contributions and just want to see a likely return on their investment, and they accept that it may only be minimal. Others see a risk and the higher rewards, and they take the chances associated with it. Likewise, you may feel like you understand the property market better, have the time and inclination to get involved in developing a property to make it suitable for a BTL tenancy, and like the idea of earning a regular income which is hopefully also providing some capital growth.
So choosing either a property or a pension investment is often down to personality, as much as it is circumstances and potential benefits. You may also find that a combination of the two investment methods suits you best. In terms of hedging your bets, this is a route that is attractive to a lot of people, and to some extent, it is another example of diversifying your investment.
In other words, you could have a single BTL property that provides a steady income and you are hopeful of some capital growth, and you can also afford to invest in a personal pension scheme. This is more realistic than trying to balance a portfolio of BTL properties with a pension scheme. Alternatively, you could tailor your pension scheme to invest in property. You can also invest in property crowdfunding, which provides the benefits of investment without the direct ownership of a property. Your risk is reduced considerably here by the percentage share you own, and you can also be involved in pension investment through SIPPs and SSAs products marketed by crowdfunding platforms.
One thing to consider if you are looking at possibly combining both property and pension investment, is the situation regarding inheritance tax. You need to be careful what pot of money you draw on first in your retirement, because if you draw on your property assets and leave your pension funds intact, at least until you need them, your dependents won’t be punished by inheritance tax in the event of your passing.
Many people consider ISAs as an alternative to property or pension investment for their later years. These are perhaps the safest way to build up a nest egg in terms of tax-efficient savings, and they are also very accessible, in that you can draw on the money at any time. That isn’t always a good thing though! And you are also limited in how much you can invest in a single year, which isn’t the case with pension funds. So again, an ISA is a good product to invest in when combined with pensions and property.
The right decision in terms of investment is very much down to the individual, and it is advisable to get good professional advice from a financial expert who can perhaps design an investment portfolio based on your circumstances and personality. This could very much involve both property and pensions, or one or the other, but the main principle is that it should involve spreading the risk and investing in a diverse range of opportunities with different routes to maturing funds, because ultimately, this is the best way to ensure you have sufficient financial resources to enjoy a happy and healthy retirement.