As you will almost certainly know, the 6th of April 2015 ushered in seismic changes in pension legislation, the main tenets of which are generally very helpful for anyone wishing to sensibly plan for and manage their retirement income, their tax position and the passing of wealth to those they care about in the future.
Where does Buy-to-Let property come in?
There has been much speculation in the media - as well as the inevitable dubious encouragement from those with vested interests - about over 55s cashing in their pension assets in order to invest in Buy-to-Let property, which has long been something of an obsession for the British.
So, what’s the problem?
The concern is that our national property ‘tunnel vision’ (often based on a multitude of misperceptions, misjudgements and factual inaccuracies), along with the relentless encouragement to jump on the bandwagon and now unfettered access to potentially significant sums of money, means there is a serious risk of very poor decisions and accordingly, long-term outcomes, for people who should otherwise be enjoying a more secure and comfortable retirement.
Let’s take a look at some of the key issues:
Tax on pension withdrawals
While a proportion (usually 25%) of any withdrawal from a pension fund will be free of tax where no benefits have previously been taken, any withdrawal in excess of this amount will be liable to income tax at the individual’s highest marginal rate.
By way of example, if a higher rate taxpayer withdraws, say, £100,000 from their pension, £75,000 of this would generally be taxable at 40%, which would amount to a tax liability of some £30,000.
Tax along the way
Unlike with Drawdown pension income (or fixed term annuities), rental income cannot be controlled and adjusted, which often means it is not possible to receive this income in a particularly tax-efficient manner.
In addition, it is important to remember that the underlying investment funds within a pension account suffer no Income Tax or Capital Gains Tax while they remain invested, which can be of considerable long-term value.
Tax on sale
Property cannot generally be sold in chunks or moved out of the tax net gradually to mitigate Capital Gains Tax, so a future tax bill might be rather larger than expected or desirable, particularly if the rates of Capital Gains Tax are increased (as has been mooted) from their current relatively benign levels.
Tax on death
For those with an estate in excess of the Inheritance Tax ‘nil-rate band’ (currently £325,000 per individual), the value of a Buy-to-Let property could well be taxed at 40% on death, whereas following recent changes to pensions legislation, it is quite possible that the value of one’s pension could suffer no tax at all on death, or at least a lower rate of tax than 40%.
Costs – the more obvious ones
There can be significant costs associated with Buy-to-Let investments, which are often poorly understood or dismissed. Initial costs can include, for example, stamp duty, legal fees, estate agents fees and furnishings. Regular ongoing costs can include insurances, service charges and replacing white goods and carpets, to name but a few.
Costs – the less obvious ones
In addition to the regular ongoing costs, there will be longer-term amortised costs, which can be notable since property is a naturally depreciating asset (it will fall to pieces over time if not looked after properly) and as such, it should be expected that the investment of hard cash will be required to maintain or grow its value.
As such, if you’re thinking of pursuing a Buy-to-Let strategy and feel it’s reasonable to assume you’ll be able to own a property for 20+ years and never need to spend any money on the bathroom / kitchen / wiring / driveway / roof / boiler etc., it may be wise to think again.
Hassle – and more costs
Many buy-to-let investors eventually sell their properties because it ends up being a real headache dealing with the many and varied associated issues. In the meantime, however, to mitigate these hassles, many investors use agents to manage their property – which in turn typically costs between 10% and 15% of the monthly rental income – and of course, there may well be void periods when no suitable tenants can be found, which can not only be stressful and worrying, but can also lead to potentially significant monthly costs having to be borne by the investor.
Risk – ‘leverage’
Property investing provides an easy opportunity to ‘leverage’ one’s capital (borrow significant sums of money against an initial – often much smaller – outlay) and for those who go down this route, it is important to remember that borrowing to leverage assets cuts both ways, since it is possible to lose more than the value of your equity capital.
Indeed, this is the curse of negative equity and as such, if you find yourself needing to sell the property for some reason, you could be forced to accept a hefty loss, or find that the illiquid nature of a residential property means that a sale in the timeframe you desire is not possible, which would not only be very frustrating, but also potentially put further downward pressure on the price at which you can ultimately sell.
Risk – poor diversification
Perhaps the biggest risk of piling (more) money into Buy-to-Let property is the concentration of risk in not just one narrow asset class – residential property – but in one house or flat, on one street in one town. Particularly where a notable proportion of your wider wealth is comprised of residential property (your home and perhaps other Buy-to-Let property), this lack of diversification is an unattractive attribute for a sensible plan to deliver a comfortable financial journey through retirement.
Risk – misinterpretation and extrapolation of past returns
There is a perception that net rental yields are very attractive and that the returns from property over the last 30 years or so have trounced those achieved from equity-based investments. However, perception is not reality, as the returns from the UK stock market during this time, with dividends reinvested, has significantly outperformed the unleveraged returns from property, and net rental yields are often nowhere near as high as people imagine.
This being said, Buy-to-Let property has, on the whole, delivered good returns during this time, but not only are these returns wrongly assumed to be higher than any other form of investment, but they are extrapolated into the future as if they are certain to be repeated ad infinitum and in a smooth, uninterrupted, risk-free fashion, which they are not. Rather, property should more sensibly be assumed to have an expected long-term return somewhere between bonds and equities.
Risk – small pots and annuities
The data suggests that the average pension pot in the UK is only around £40,000 at retirement, which might imply that the average person seeking to use their pension to help fund a Buy-to-Let purchase may well have to withdraw all of their fund, which, as outlined above, is likely to raise the prospect of a tax charge and / or borrowing to facilitate the purchase.
However, it may also imply that for someone in these circumstances, it would likely be very sensible to seriously consider purchasing an annuity, which will provide a secure income for life and will ensure one is not exposed to the vagaries of the property (or investment) market, which is likely to be important for someone who, in truth, probably does not have the financial capacity to absorb the risks associated with them.
What about someone with salary-related pension benefits?
While there are circumstances in which a transfer out of such a scheme might conceivably be appropriate, in almost all cases this will be an unwise course of action and leaving a secure salary-related scheme to help fund a Buy-to-Let property purchase is likely to be foolish in the extreme. In short, do not even contemplate doing this without seeking professional advice first (if the transfer value is £30,000 or over, you must receive professional advice in advance of any actions being taken).
So, to summarise all of the points from this article:
Property and pensions are not mutually exclusive
Property can certainly have a place in an investor’s wealth plans, but this does not have to be at the expense of all other retirement income vehicles and nor does it have to involve highly concentrated and unnecessary risks. Indeed, property ownership / exposure does not only have to be in the form of Buy-to-Let; instead, or in addition, exposure might simply be through one’s residential property or through an allocation to commercial property, as part of a well-balanced and diversified pension portfolio.
Pension income should remain as a core pillar of retirement
Buy-to-Let ownership should certainly not be regarded as a quick and smooth road to riches. It has material costs, risks and downsides unacknowledged by many who embark on such a course. It demands to be managed like a small business (which holds a depreciating asset that needs constant love and attention in order to achieve an expected rate of long-term return somewhere between bonds and equities) and while for some that is an enjoyable pastime, for others it becomes a headache, a chore and a source of stress.
In Chamberlyns’ view, converting one’s pension funds (or a proportion of them) into a secure lifetime annuity will be the safest, most sensible course of action for many over 55s, while for those with appropriate circumstances, making the most of the significant planning opportunities provided by pensions and investing in a sensibly structured, globally diversified pension portfolio will continue to make enormous sense, and is likely to remain at the centre of a well-considered and balanced retirement / wealth plan.
As a final thought, what price can you place on the time that you free up to do the really important things which enrich your and others’ lives, by not overburdening yourself with the hassle of managing properties, especially in the years when you should be living life on your own terms?