Property vs Pension

For as long as I can remember people have asked the question "property or pension".

The news this week highlighted that the proportion of adults in the UK who believe property is the most lucrative way of saving for retirement has increased to an all-time high. Higher than those who believe in a pension scheme.

All sorts of factors impact on which is most attractive, and some are more objective than others. And, of course, I'm biased – I've worked in pensions for over 25 years. But in this article I've looked at the issue and tried to be objective as possible.

I'd welcome comments. Where I've misunderstood and have something to learn please tell me - I'm very happy to update the comparison.

I've captured my thoughts, in ten areas, and scored each of Pension and Property out of 10 to give a grand total out of 100.

At outset it's worth making clear that I'm going to make the sweeping assumption that the pension in question is Defined Contribution, because very few people have the luxury of a Defined Benefit (Final Salary) pension now. And I'm going to assume that they are invested in equities(at least up until retirement). Partly because that's the most common investment used. And partly because if I assumed a pension was invested in property then this whole comparison would cease to be interesting.

For the property I'm going to assume it's a buy-to-let rather than the property that you are living in. But I've commented below where this is relevant.

So off we go ...

1. Potential Returns

Let's start with which one returns most. Predicting the future is difficult, so I'm going to look to the past. 

The UK House Price Index goes back quite a long way. So does the FTSE All Share Index. Both suffer from the fact that components change. Houses have got larger (on average) over time, whereas companies in the FTSE change regularly as new companies take over from old. But despite these flaws I pulled up data for both indices over 40 years – the length of a typical working lifetime. To save you reading pages of data, I've summarised the returns below in 5 year bands:

What the table shows is that in four out of those eight periods property outperformed equities (the green cells), and in the other four periods equities outperformed property. So feels like a draw.

What I found even more amazing is that when you do a simple average of those returns you get the following:

Can I say straight away that this wasn't fixed – it was the first result that I came up with.

Now all of this is flawed by the fact that properties generate rental income, and equities generate dividends. But as I don't have the data (or time) to analyse that I'm going to assume that they cancel out.

So my conclusion on returns is that they are both good, and it's hard to make a call between them. Of course, if you live in the property that you're planning to use instead of a pension then you don't get rental income, so your returns are materially lower.

I've therefore scored them as follows:

2. Charges

Charges are very topical so perhaps worth going there next. This gets more complex.

Running an equity fund - whether in a pension or not - clearly has charges associated with it – perhaps 0.25% pa or less for a tracker fund, rising up to perhaps 1% if you want to pay someone to be really active.

Running a property also has a cost, but it's harder to determine. For a buy-to-let, a fully managed property service can cost 15% of rental income, whereas just a finders fee can cost 10%.

There's also the cost of maintenance. I don't have any data on that, but HMRC allow a "wear and tear" allowance of 10% on furnished buy-to-lets. As so many properties are let unfurnished I've arbitrarily halved that to 5% of rental income, as even unfurnished properties need maintaining.

Then there's ground rent and service charges which, for many flats, make the costs even higher. And insurance, of course.

Conservatively, I reckon that gives properties a typical running cost of around 20% of rental income. Based on 5% rental yield that's 1% of the property value a year, but it could be more or less.

So a single score is tricky as it depends on what type of equity fund you have, and whether you do your own property management. So I'm going with ranges as follows:

3. Diversification

Not everyone will think this is important, but I do. The old saying is as relevant now as it was when eggs really were put in baskets. Nobody (well hardly anybody) buys a share in a single company because the risk is too great. Holding shares in many companies is more stable than a single one. And holding shares in many countries more stable than a single one. Diversification beyond equities is clearly also possible (indeed easy) within a pension. But even limited to equities it's possible to diversity across companies, countries, sectors and sizes.

Property diversification is almost impossible, because each one is so large. Google tells me that the average pension pot in the UK is around ￡50,000, which isn't going to buy much of a property. Even those looking forward to a very prosperous retirement would struggle to put more than 2-3 properties in a portfolio. And each of those properties is exposed to extreme events – factors affecting your area (think HS2 or the Channel Tunnel rail link), natural events (subsidence, flood), perhaps even squatters. As well as more mundane issue like vacancies between tenants, rent arrears etc.

So I'm going to score this one heavily in favour of pensions.

4. Volatility

We've seen in recent days how much equities can bounce around, and a quick look at any equity and property index will tell you that property prices are far less volatile. To prove the point in a simple way I pasted the same 40 year data used in 1, calculated the quarterly percentage movements in price (because the old housing data was only quarterly) and then calculated the average quarterly movement (treating, for example, +3% and -3% both as +3% so that they didn't all just cancel out).

That gave the following table:

Now I know this isn't the same as volatility but it's a simple way of making the point, that equities are over twice as volatile. Of course property can be volatile too (think to 90's housing crash and negative equity) and pensions can be made less so. But rather than get into that complexity I'm stopping there and giving scores as follows:

5. Tax

This one is going to test my knowledge, but here goes.

Pensions get tax relief on the way in, tax-free roll-up, but are then mostly (but not wholly) taxed on the way out. There is big tax deferral benefit for two reasons: 1) the tax free roll-up and 2) the fact that many people have a lower tax rate in retirement than while working. But the biggest impact is the 25% tax free cash that can be taken from a pension scheme.

Property, on the other hand, is subject to tax at all stages. Stamp duty on the way in, tax on rental income (which then needs to be re-invested and will get taxed again), and tax on capital gains when you sell. The tax relief that used to be available on buy to let mortgages is also reducing, so all in all that doesn't sound attractive.

"But wait", I hear you say "what about the thorny issue of annual and lifetime allowances for pensions, which mean that the tax benefits disappear rapidly?"

That's true, but relatively few people are affected by those, and if they are then the Pension vs Property question becomes irrelevant as Pension ceases to be a realistic option. So I'm going to ignore that.

I'm happy to refine this if someone can provide a more rigorous comparison of the tax positions, but for now my scores are as follows:

6. Liquidity and ease of exit

At some point there comes a time to sell up and start living off your pension/property. This is an area where property looks challenging.

Equities can be bought and sold easily, and you can sell part of your portfolio at a time. Gradually running down your equities to fund income needs is easy to do, and with drawdown now available to everyone it will only get easier. You can flex how much you take in a year - although the volatility risks mean you do need to be careful.

Property, on the other hand, can takes months to sell, and you can't sell it "in parts". Rental income does provide an income stream, which is a positive, but the only way to properly access what you've saved is to sell it at some stage.

Finally on this point, pensions are limited to being taken after age 55, whereas a property (or the income that it generates) can be used at any time.

So both have drawbacks and I'm going to score them equally:

7. Inheritance

The "freedom and choice" pension changes in 2015 had a big impact here, as the 55% tax on death was removed and pension assets can now be passed on free of inheritance tax.

Second properties, on the other hand, are subject to inheritance tax, while main properties have some exemptions. So on this measure I reckon that pensions are the clear winner.

8. Security

One of the biggest factors damaging pension schemes in the UK has been the "scandals" that have engulfed the industry. Pension mis-selling, Equitable Life and Maxwell all live on in our memory. And more recently cases such as BhS, Carillion and others have reminded us what happens when pensions go wrong.

But for this comparison we're not interested in DB schemes which have companies sponsoring them, so the risk of losing benefits and entering the PPF because of company collapse can be ignored.

For a plain DC scheme with a fund run by a reputable investment manager, I see relatively little danger. The less-than-transparent funds such as With Profits are almost non-existent now, while managed funds are well regulated.

As for property - it seems to me that there isn't really much risk, and properties tend to be insured against the worst outcomes. So unless you have an un-insurable property (maybe that one on the edge of the crumbling cliff) then that feels pretty secure as well.

So I'm going to call this one close to draw, but with the edge to property as in theory there are still some with-profits funds out there.

9. Who pays?

A huge positive about pensions is that often someone else (your employer) will pay into it. Most company pension schemes will see the company pay at least as much as the member, which means that overnight a member can double their money. And auto-enrolment means that this position is enshrined in law up to a certain point.

Of course, not everyone has an employer who will make such payments. The self-employed and non-workers won't have that luxury, while some employers will only pay the statutory minimum, no matter how much the member pays.

In comparison, I'm not aware of any company paying towards employees' properties.

So my scores, recognising the range of possibilities, are:

10. Perception

And finally ...

This one is very intangible but I think it's important. Pensions have suffered from poor perception for many years, and regardless of whether it is justified or not, and who should have fingers pointed at them, that has a damaging effect.

Individuals need to be comfortable with what they are investing in, and if someone isn't comfortable investing in a pension (either because of the perceived risks or because they don't understand the investments that it holds) then that may be a good enough reason to do something else - perhaps invest in property.

I remember listening to anecdote from many years from Malcolm McLean, who headed the Pensions Advisory Service at the time. He had been speaking to a customer and the conversation went along the following lines:

For me, that summed up the problem that pensions have. People are worried about them but often don't understand why.

Of course, property isn't immune. Negative equity in the 1990s, tax breaks being taken away, and risk of squatters in vacant properties all pose risks. But they don't appear to damage the property "brand".

So for the failing reputation of pensions, I score as follows:

Totals

Adding up all of those gives the following:

This is clearly somewhat subjective, but it seem to me that anyone who has a company willing to pay towards their pension, the decision to use a pension is pretty obvious.

Where there's no company contribution the comparison is closer, but for me the tax breaks and flexibility (both liquidity and diversification) still make a pension scheme the preferred choice.

If you have enough money that you can afford both then you're probably affected by the Lifetime and/or Annual Allowance anyway, so max out on pensions first and then move to property after that.

If you cannot (or will not) tie the money up until 55 then of course all of this irrelevant. Pensions aren't for you.

But if you have a fear or distrust or dislike of pensions and, like Malcolm's caller, can't explain why, then do me a favour and take another look. Maybe pensions aren't as bad as you think.