Attempting to help people understand how to compare buy-to-let investment returns against a pension is obviously a very good idea. This article from Kate Faulkner on Landlordzone makes a decent fist of starting to consider some of the factors involved in assessing a buy-to-let investment, so that we can compare it with a pension investment alternative. In sharing today’s article and in my opinion there are some flaws or at least some wrong assumptions made within it. So, as strange as it may seem, I am going to say please do look at this article to gain a better understanding of the issue but in conjunction with some of the comments included in my insights here 😉
So, when looking at comparing a pension to a buy-to-let investment we need to consider a range of different factors such as, returns, tax, leverage, inflation, risk and leaving a legacy.
OK, so let's look at the different investment returns available to start with. A pension investment, whilst not always the case, is often invested into shares and so in comparing the two here I work on the assumption that a pension is invested in shares via a FTSE250 fund. According to the excellent Moneystepper article the average returns over the past 30-40 years for property and shares are as follows:
UK Property - Buy-to-let investment
Capital gain 7.6% per annum
Income yield 5% (i.e. gross rents an assumed figure - fair enough but could be higher in reality according to some measures)
Total annual gain 12.6%
UK FTSE250 (a probable or at least potential destination for pension investments)
Capital gain 8.9% per annum
Income yield 2% (i.e. average annual dividends)
Total annual gain 10.9%
So, that’s 1-0 to property I think
Next, let's look at tax a little, as this can get very complicated.
I agree that if we sell a property then there will be capital gains tax to pay on our profit and the charges quoted in the article are correct. However, I say don't sell the property and therefore don't pay the capital gains tax! In addition there will be income tax to pay on net rents after deducting allowable costs and expenses this is also true. This effectively reduces the net returns of property - how much by is difficult to calculate, as rents won't stay the same over the investment period and I could also argue that the returns quoted should really be after tax as they are on the lower side. But let's say the net return after tax during the investment period is reduced to 4%. Tax on rental yields in retirement will be the same as for a pension.
Sheltered within a pension the growth and income will be free from tax providing the limits set by the Government (£1.25m lifetime fund & £40k pa annual contribution value wef 1st April) are not exceeded. In addition, the taxman will top up the contribution into a qualifying pension by our highest tax rate (subject to paying enough tax at that rate to cover the actual contribution). In this example, the initial investment was shown as £33k and so the taxman would add in £6.6k if we are a 20% tax payer, or a whopping £13.2k if a 40% taxpayer, to further boost the starting fund. Tax on pension income in retirement will be the same for a property BUT with a pension you can take 25% of the fund as a tax-free lump sum. I would argue that pension fund fees, a factor with investing into a pension, are akin to a tax charge also but have ignored this for now here but it is still very relevant when considering where to invest our pension fund investment.
I have to concede that this is a clear winner for pensions and so that's 1-1
Leverage
In fact you can use the benefits of leverage with both forms of investment. By leveraging our investment fund, we effectively get to multiply our total returns by increasing the total value of our investment
With a pension this comes in the form of the taxman’s contribution of returning tax we pay into the pension, which is generous in fact. In addition, if this contribution was made via a company pension and the employer also matches the contribution then that contribution is another form of leverage to top up the fund. But looking at this example of a single contribution into a pension outside of a company pension the effective leverage benefit for a 20% taxpayer would be 120% of the investment (or 140% for a 40% tax payer) – that’s pretty good. So our overall annual return can be said to be leveraged up (or multiplied) by 120% to 13.1%.
With a buy-to-let investment, we can use a mortgage to make our money go further and buy a bigger property than our funds would allow. In this example, a 75% loan to value mortgage was assumed to be taken out and so this means that our leverage is 400% (£25k investment x 4 buys a £100k property along with a £75k mortgage).
However, the leverage here comes at a cost as we have to repay the lender by paying interest sadly. Calculating the impact of these costs is a bit tricky as the mortgage debt will remain the same, assuming an interest-only mortgage is taken out, or will reduce gradually over time with a repayment loan and equally interest rates will vary. In addition, rents will increase over time to offset some of this cost also. But let’s assume that the loan interest takes two thirds of our rental returns away overall for simplicity’s sake and so we end with a calculation something like this: 12.6% (overall return) less reduction for interest payments of 3.4% (5% rental yield x 2/3rds) leaving 9.25%. This is then leveraged (or multiplied) by 400% but we also need to allow for the repayment of our loan, which for simplicity’s sake here, we will reduce the leveraged value to 200% only, making the total annual return 18.5% (9.25% x 200%). Now that is impressive isn’t it?
We could also argue that we would have to sell the property in order to settle off the mortgage but with buy to let we can usually still get a loan into your seventies and a company could get a commercial loan regardless of this fact it the property was owned in this way (might mean changing ownership structure). Equally, we could look to buy two properties and sell one to settle off the debt on the retained one if we don’t like the idea of having debt later in life.
I think that’s probably a 2 goal bonus for property in reality given such a magnified return but let’s leave it at just the one taking the score to 2-1 in favour of property.
Inflation
The article makes what I believe to be a false assumption in this respect, as it suggests that a buy-to-let investment will be adversely affected by inflation when a pension will not. In fact both will be affected by the eroding effect of inflation on the overall return but given that the overall returns of property are higher it will in fact be affected less by the eroding effect of inflation when compared with a pension. Again, as Moneystepper show - reducing after inflation total returns to 6.9% for property and 5.2% for the FTSE250, Plus, if we factor in the leveraging effect mentioned above and also, if we want an index-linked pension, it will reduce the annual income we receive in retirement with a pension, so this would extend this gap even further.
That’s 3-1 to property for me.
There are one or two additional factors to consider, as with any form of investing:
Risk and diversification (actually a form of risk). So, let’s lump these together under the heading ‘concentration risk’.
We have seen already that over a long time period that property returns are higher than those of the FTSE250 and both markets have crashes it is fair to say. So, the big difference here really comes in diversification or concentration risk in my personal view. If we invest in a pension, which is in turn invested into a FTSE250 fund, then by definition we have spread or diversified our risk across 250 different individual investments. So, if one company performs badly or even goes bust (e.g. Woolworths, Comet, etc.) then there will be plenty more to cover this loss. But if we invest in a single buy-to-let investment and a nuclear power station is then built around the corner, then it could severely affect our property investment performance without similar ability to cover it elsewhere. So, in this example of a single property versus a pension invested into a FTSE250 fund, the pension is the clear winner.
That brings it back to 3-2 to property
What about leaving a legacy to our children?
Well, with a pension we can opt to have a spouse’s pension, so that an income continues to be paid to our partner upon our death but this will only be for the surviving partner’s lifetime and in any case, as mentioned earlier, it comes at a price in the form of a lower initial pension payment. The pension fund we have accumulated cannot be passed down to our children or other benefactors.
However, with a buy-to-let investment property there is no such limitation and we can bequeath our property to our children or whoever we want, so that they can enjoy the benefits of our hard earned investment. Sure, there MAY be some inheritance tax implications but even if we end up paying a bit of tax back to the Government we are still left with a transferable investment to hand on as a legacy. So, here once again property scores for me.
I make it 4-2 to property now…
So, what does this mean – does it mean that we should all ditch the pension and immediately rush out and buy a property? Does it mean that if you are so painfully risk averse that there is no way on earth you can consider sticking everything into a terraced house in Nottingham, in the fear that the next Selafield is built next door? The correct answer in actual fact is that it all depends on you and what you are comfortable with. As always, I am not a financial advisor and I never give financial advice, so please do not interpret any of my opinions as such and seek your own professional advice. But for me I would have both 🙂
I know that’s a cop out but I would take advantage of the tax breaks of a pension, especially if we have a company contribution layering in on top but equally I would have at least one or two buy-to-let investment properties in addition, which by the way further reduces my concentration risk!
In reality, I am already doing this and also have an ISA along the side, so hopefully with this diversified approach and commitment to saving and investment; I can at least have a relaxed outlook when I eventually take up crown green bowling, gardening or Atlantic cruises one day 😉
Originally produced on our Scoop.it newsfeed in March 2014 - all references relevant to then, as things change...