Pensions

Historic pension arrangements

Over recent decades the pattern developed for most people of creating a pension was, either by paying into a works scheme that was often associated to a percentage of their final salary, or creating a pension fund by contributions, where a sizable proportion of these contributions were invested for growth.

Equities have historically tended to constantly rise, largely driven by the large sums invested by pension funds that had to be invested, hence a shortage of shares available in proportion to the funds available. With changes to a global market and more types of investments available there is no longer the need to buy equities, however they still are favoured as a large percentage of the funds portfolio as they can present rapid growth and they have rapid liquidity advantages, in that you can turn them back into cash when required. Some favor them because that's the way their system works. Regulatory arrangements may also stop true independent advice being used to get a better and safer deal.

Historically there has been very little organized for the majority of people in relation to property being used for pension growth, although there are a small number of funds that have invested in commercial property. It has therefore been individuals taking their own initiative rather than schemes that have provided the growth in property ownership to build a pension fund or wealth. Some individuals have done so very successfully.

Some pension funds purchase a form of bond, where payments are made partly from capital and partly from interest, calculated so as to last your expected life time and then run out. Pension schemes based on equity do not pay based on income from a fund and on your death pay back the capital fund, as many property arrangements can.

Historically people needed pensions for relatively few years, perhaps only 10 years after retirement was the norm.

Future pension needs

Improvements in health and medical procedures has meant that many more people are living far longer. Therefore rather than funding a pension to last for 10 years before running out, you now have to think of making sure a pension will last for up to 35 years or even longer. If you don't want to ultimately end up with very little the capital fund has to be able to increase in line with real inflation at least, as well as allowing you a good standard of living. Due to the increase in the number of pensioners and smaller family sizes, the state model of state old age pensions, where each generation paid the pensions of those in retirement will no longer work, and is being phased out. So those who have no pension arrangement that can cope will end up with means tested state support, and due to the numbers even this is likely to become thinner.

Equity based funds are risky, a gamble at the least, as there is no actual tie up between share prices and value, therefore when one sells, others copy, dropping prices and if enough people get confidence then others buy as well, increasing prices. A single bit of gossip, weather condition the other side of the world, or what the media say can cause shares to move wildly up or down.

Growth with equity tends to require high payments and many years to grow a large fund, especially as for the first years it has to first recover the commissions paid out. For many self employed and others who have not had a good pension arrangement, by the time they come to look at it, the payment required to build it over a shorter time would be far more than they could possibly afford.

Gearing is not possible with share dealing in the same way that it is with property, if you used gearing with shares you would probably end up bankrupt very quickly.

Property in pension arrangements

Residential property is more price stable as it is tied to three factors the cost of construction, the shortage of land on which to build, and shortage of people able or willing to construct new homes. 

Whatever happens to the world weather, what the media say or similar, if you are in rented accommodation then you still have to pay the rent, and if you can't for some reason, most will qualify for housing benefit that will pay at least a sizable proportion for them. The need for homes continues to grow, there are more single people who are choosing to have a home of their own, more people each year divorcing creating the need for multiple homes, large numbers of immigrants and movement within the UK putting more demands on housing in preferred areas or where the salaries and conditions are considered better.

In recent years there has been a considerable growth in the 'buy to let' market, with far more mortgage sources becoming available. Currently in excess of a million people in Britain own more than one property. Although a few people have lost money, the majority have done very well, mainly due to the rapid rising values of property. When property prices rise so rapidly, no skill is required and the rise in price masked the costs of paying too much or making conversion or other mistakes. 'Build to let' offers far greater rewards, and growth even if a  time came when property prices started falling, but us not so well understood by most buy to let investors.

One of the major reasons why those who have chosen to use property to build their wealth, have increased their value far faster than by investing in any other form, has been the effect of gearing.

The following example is simplistic, but illustrates why the gearing effect associated with property has worked so well.

A fuller illustration of gearing can be found in the gearing article in the buy to let section, where we look at compound gearing, which can produce some spectacular results.

In addition to this the property would be rented out producing initially a return of around 130% of the mortgage costs, and has risen in line with the value of the property, so by half way through is returning in excess of double the mortgage payments.

When prices do not go up, equity produces very little, maybe some small dividends, property however that you have held for some time is still producing at least half the rent. Although it would never happen, ultimately if both fell to zero value, with equity you would have a piece of paper you could frame and with property a house you could still rent out.

Tax

Tax is something that has of course to be considered, equity based pension arrangements have beneficial tax treatment, but what about property. Costs such as mortgage interest, agents fees, maintenance etc is of course allowable, but tax has to be paid on the residue cash produced. Tax on the increase in value of the property only becomes payable when or if you sell it. So people who have built portfolios of property re-mortgaging some as they increase in value to allow more to be purchased have built portfolios over time worth many millions, without ever having paid a penny in tax on the increasing value of their holdings. If they put groups of properties into companies, and then later rather than selling the properties they sell the companies again they pay no tax on the increasing value of the properties, although they may pay it on the increasing value of the company, the reason I say 'may' is that each person each year has an exempt amount of investments profits before tax is paid so if  the payment for the company is made in stage payments it may be possible quite legally to never pay any tax on the increased wealth. Most people however although wishing to minimize their tax bill as far as they can legally, do not object to paying tax on excess wealth, after all they have the money to be able to pay it many times over.

Future prices of property

Very few people would say that in the longer term property prices would not rise, after all they have always done so in the past. Often you will see a short period of correction, you see prices increase rapidly, then for a short period either drop back just a fraction or stand still, before rising again.

So what could cause a risk of prices not increasing. Overall the only reasons this can come about is drastic increases in mortgage rates or lenders being unwilling to lend.  At this time more and more lenders are joining the market and more international investment is looking our way.

The current government have made it no secret that they would like to join the Euro, towards this end they wish to keep down our interest rates and possibly reduce them further. If they have their way, and we do join the euro, if other countries experiences are anything to go on,  or our own experience here of decimalization all prices of everything, but especially property will rise. Removing the currency risk will open up all the European mortgage sources to us with lower interest rates and fixed interest for very long periods, so we can expect then property prices here to rapidly rise.

So what else could cause property to loose its appeal. Some suggest that building on green belt land becoming easier, but the number of homes needed is far beyond what could be constructed, and if homes suddenly became available more people would be inclined to move so perhaps some areas of the country would have surpluses, but in demand areas the need would never be met even if every field was built upon and we all know that most people believe there should be more land to build on, but just not near to them, so every piece of ground will be defended to the full. Think of the fuss about building just about any new section of  road.

As now, some areas will of course do better than others, some producing better growth, others producing greater returns on capital invested. It may be that a number of individuals and companies will fail as they do in any type of venture, and we cannot expect in the future for people to be able to make the profits they have historically without getting the formula right and knowing what they are doing. 

While property has many advantages as a means of building wealth and creating pension funds, the difference between the best and worst returns we can expect to widen greatly, with far more co-operation required between people with knowledge in these areas, and a greater understanding of the variables and factors that can lead to greater success. 

Industrial and commercial property such as offices, factories, industrial estates and shopping centres, hotels, public houses, land freeholds of blocks and more, provide more opportunities, but in many cases require larger capital sums and more expertise if the risks encountered are to be fully controlled. However owning a large office block let long term with regular rent increases to a government agency, may be easier and at least you know your client can always afford the rent. 

In many cases for individuals to get the best from investments in to these markets, they would need to become part of joint ventures. The risks are greater due to the problem of 'voids' or unlet periods, while if you had a number of houses it would be unlikely that more than one would be empty at any time with still the need to pay the mortgage (insurance against this is also available) with all your investment in a larger unit an office or factory unit could stand empty for some time. In any city or town you will see newish buildings that appear to have been empty from near completion and while the increase in value may still make this a sensible holding the mortgage has to be paid, therefore the cash management and calculations have to be analysed differently, should the property fail to increase in value greater than the interest rate, you can get into considerable problems. Nearly all  property companies that run into problems are in the industrial or commercial market. It is not quite as risky as it sounds as the mechanics are quite well understood and with the right expertise, this can be included as a part of a balanced plan.

Property pension funds based on the equity model

We may see some of these develop. However at present without changes in the tax system the charging structure they have employed with equity portfolios do not work very well. Most equity funds even in good times perform less well than either the average of all shares or what most investors could do themselves if interested, due largely to the economies of scale forcing larger transactions to be used and  cost structure, funding commissions, large offices etc.

At the moment the informed individual or private company can outperform any other model available, even when  poorly informed or not fully understanding the mechanics that maximize return, with a little skill the results can be nearly unbelievable.

The need for balance

While at first sight we may have appeared to make the case completely for using property as a pension generator, we are not presenting  advice as a financial advisor, do not know the individual circumstances of any individual or  the details of any pension scheme they are currently in.

As in most things a balance is best if it can be achieved, and therefore if you have an existing pension arrangement perhaps you should look at maintaining or even improving this provision by conventional tax efficient means, but also look at what you could do in relation to creating an additional wealth fund from property. Many people who have moved on to 2nd and larger numbers of property have done so by using the 'idle' equity within their own home, so have been able to build wealth without costing them anything or reducing their standard of living.

Zero cost pensions

As often property can be obtained without any actual cost (explained in 'buy to let' section), and the operation can be repeated, large pension funds can be built at no actual cost. 

This may to some seem too good to be true, but, 1 in 10 people in 'buy to let', now have 10 houses or more according to one recent report. If they understood it many of these could make even more with 'Build to let'.

Very many people, and more every month are achieving this, although not all are getting the full advantage of buying wise and fully understanding what they are doing.  Property historically has been so profitable that even those who make major mistakes have become wealthy.