Is property investment or pension saving the best option for your bonus?

Is property investment or pension saving the best option for your bonus

If you’ve invested in a pension and not property, look away now

Property investment opportunities or pension savings? That’s the option you could be faced with if you receive an inheritance or large bonus from work.

If you don’t need the money now, you’ll want it to grow until you do need it. That could be through to retirement when you might then want an income from your investment.

In this article, we compare the potential returns on an inheritance of £30,000 should you decide to save it in a pension scheme, to using it as a deposit for investment in buy-to-let property. After all, you wouldn’t want to make any of the common pension mistakes, would you?

Before we get started, let’s make a few assumptions

We’re going to make some assumptions in this article. The first is that you’re a basic rate taxpayer. So that inheritance or bonus will benefit by grossing up for tax when you invest it in a pension.

We’re also going to assume you’re 35 years old and want to retire on your 60th birthday. So, your investment is going to have 25 years in which to grow.

We’re going to assume that the rate of growth in a pension fund and property is the same over the long term. We’ll see later that this certainly hasn’t been the case over the last quarter century.

We’ll also assume that the interest rate on your buy-to-let mortgage would remain unchanged at 4.5% throughout the 25 years and that the gross rental yield remains at the current national average of 5.6%.

Pension investment – how much might you get over 25 years?

Okay, so first things first. You’ve got £30,000 to invest. When you make a pension investment, you’re going to make a big win to start. It is because you will receive a gift from the government that you don’t get when you invest in property. You get tax relief on your investment amount. In this case, as a basic rate taxpayer, your £30,000 will kick-start your pension with £37,500!

So, how much could you expect your investment to grow by over the next 25 years?

Using this handy pension calculator, we can enter the parameters for this investment. We select the following:

  • A current pension pot of £37,500. Entering this amount will allow for the initial investment of your bonus or inheritance.
  • No monthly contributions. We want to see the effect on a one-off investment.
  • No employer’s contribution, either.
  • Your age – 35 years.
  • Your planned retirement age – 60 years.
  • Annual increment on payments – 0%, because there are no regular payments to be increased.
  • Management fee of 0.5% – which is, according to the Pensions and Lifetime Savings Association, the average paid in the UK.
  • Use a growth rate of 5%, which is the medium growth rate used for illustrations and set by the Financial Conduct Authority (FCA).
  • Assume inflation of 1.5% – this allows for a comparison to spending power today, were inflation to average 1.5% over the period of investment.
  • Then click ‘next’, and you’ll see that investing your £30,000 bonus into a pension for 25 years has produced a pension pot of £120,183.

Property investment – how much might you get over 25 years?

The calculation is very different and easier to make with a property investment.

Let’s say you use your £30,000 as a 25% deposit on a buy-to-let property valued at £120,000. The value of your property grows at a compounded rate of 5% per year. After 25 years, your buy-to-let property would be worth £406,362.

If you decided to sell your property at the end of the period and repay the mortgage of £90,000, you would be left with a gross fund of £316,362. That’s almost three times the amount you would have by investing your bonus or inheritance in a pension plan.

Of course, you would be liable to capital gains tax on this gain. But even so, you would be hundreds of thousands of pounds better off.

Why is the final value so much better when you invest in property vs pension?

In a pension fund your money grows tax-free (almost). This benefit is far outweighed by your ability to leverage and make money on other people’s money when you invest in property. By using a mortgage to invest in property, you benefit from growth on the entire value of the property because you are banking the benefits of leveraging in property investment.

Property investment is more flexible, too

When you invest in a pension, you are locked in until you retire. You could take benefits earlier (even before the age of 55 years), but doing so is likely to suffer a tax penalty of up to 55%.

When you invest in property, you retain maximum flexibility. You can sell at any time you want. You can retain the property and bank the rental income. You can hold the property and bequeath it to your loved ones. You don’t have this flexibility or range of options when you invest in a pension.

How does the income potential stack up?

When you convert your pension to retirement income, the traditional route is to buy an annuity. Today’s average annuity rate in the UK is around 4%. So, on the pension fund of £120,183 (and this assumes you don’t take a tax-free cash lump sum of up to 25%), you would be paid £4,807 per year (as a ‘level payment’). A level payment would be paid for life until you die. When you die, your annuity dies with you.

You could benefit from inflation proofing when you buy an annuity, and leave a pension to your spouse until he or she dies. Doing either drastically reduces the retirement income you will have at the outset. As an example, a friend of mine recently got an annuity quote on a small pension. The level payment worked out at £192 per month. The inflation-proofed payment started at £73 per month. It would take 19 years for his monthly income to reach the level payment amount he could obtain now.

Now let’s examine the rental income from buy-to-let investment:

  • Today’s average rental yield is 5.6%. With a property valued at £406,362, your gross rental would be £22,576 per year.
  • Of course, we mustn’t forget you are paying mortgage interest of 4.5% on your outstanding mortgage of £90,000. That’s £4,050 per year.
  • You will also pay investment property management fees of, say, 10% of your gross rental income. That’s a further cost of £2,257 per year.
  • Allowing for a maintenance bill of 5% of rental, there is another cost of £1,128 per year.
  • After these deductions, your net rental income will be approximately £15,141.

It is, of course, an illustration only. It doesn’t allow for the effects of the tax on your income – but both pension income and rental income are liable for tax. How much tax you would pay depends upon your circumstances.

Property investment and stock markets don’t grow at the same rate, do they?

No, they don’t. For example, if you’d bought an average-valued property 25 years ago, you would have paid £54,547 (as measured by the Nationwide House Price Index). Today the average house price is £205,937. That’s capital growth of 277%.

During the same period, the stock market (as measured by the FTSE 100) stood at a points value of 2847. Today, the stock market is near an all-time high, at 7550. That’s capital growth of 165%.

Not a very healthy comparison, if you’re an investor in stocks and shares (which is what most pension funds do).

Okay, but what about funding the property before retirement?

It is a question I knew you were going to ask. What if the property investment is cash flow negative and the costs (mortgage interest, property management fees, maintenance, etc.) total more than the rental income? In this case, you’ll need to subsidise the investment with other income. Which is why it’s important to buy the right property, with a cash flow position that you are comfortable with.

And this is where we come in. Give us a call today on +44 (0)207 923 6100. We’ll discuss your goals and objectives, understand your financial position, and source the best property for your needs.

Live with passion

Brett Alegre-Wood

About the Author

Brett has over 20 years experience in all facets of property, he owns various companies centred around property and is the driving force behind the education and training at Gladfish. His companies have sold over £850 million in UK and London property and he manages over 1200 properties through his estate agency chain. Today he shares his time between UK, Australia and Singapore. He is married to Arlene and together they have 4 kids.

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