Key Post Pay down your SVR mortgage before starting a pension, but don't leave it too late

Summary of thread's conclusions (but it's worth reading the thread in full, as differing views are discussed)

1) If you have a cheap tracker mortgage, you should not pay it off early. Putting any spare cash into a pension fund(or some other investment) would be a lot better.
2) If your employer matches your contribution to a pension scheme, then you should contribute the maximum to the pension scheme.
3) If you are saving the deposit for a house, you should not be making any contribution to a pension scheme (unless your employer is matching your contribution)
4) If you are not paying tax at the 41% rate, you should not be contributing to a pension scheme
5) If you have an SVR mortgage, you should pay it down to a very comfortable level, before contributing to a pension
6) At around the age of 40, you should prioritise pension contributions over accelerated mortgage repayments.
7) If you die, your estate will get your pension fund tax-free, so if have a terminal illness, maximising pension contributions is very tax effective.


Explanation
Overpaying your mortgage is a very good means of saving. In effect, you are getting a 5% tax-free rate of interest. This is the amount of interest you save by paying down your mortgage.

The other big advantage of overpaying your mortgage is that you may well qualify for a lower mortgage rate if the loan to value is low. For example, as of October 2014, you could refinance an ICS mortgage costing you 4.8% to KBC at 3.7% if the Loan to Value was less than 50%.

There are tax advantages to contributing to a pension. But you can avail of these later, after you have paid your mortgage down to a reasonable level. If you pay down your mortgage first, when you reach age 40, your mortgage repayments will be a lot lower and you can put these in your pension at that time.

While there are tax advantages to contributing to a pension, they are usually overstated. You get tax relief on contributions, but when you draw down the pension, you will pay tax and USC on the pension. Under current rules, you will get around 25% of the fund tax-free on retirement. The limit on this has been reduced in recent years, and it could be reduced further before you reach retirement. The uncertain tax treatment is another good reason for delaying pension contributions until later in life.

There are some situations where delaying contributions to a pension may be disadvantageous

If you wait until your mortgage is paid off in full before contributing to a pension, your circumstances may change and you may not be able to exploit the full tax advantages of pension contributions

• You may not have enough years left to build up a fund of €800,000
• Your earnings may reduce in later years, due to
  * A reduction in income
  * Loss of your job through illness or unemployment
  * A wish to take early retirement
• A future government may reduce the rate of tax relief on pension contributions, in which case, contributing to a pension fund now while you can get tax relief at 40% would make sense.

As a result, you should start prioritising your pension contributions over mortgage repayments from around age 40.

The other point on which I find it difficult to make up my own mind, is the advice to pay down the mortgage to a comfortable level before starting a pension plan. There is something a bit "half pregnant" about this statement. If it makes sense to pay down your mortgage surely it makes sense to pay it down completely. Yet that would mean folk starting their pension plan at earliest in their 40s and that seems wrong. In other words there does seem to be some case, and I shudder to admit it, for people having a geared position - owing say 100K on their mortgage but having accrued a pension pot of €100K.

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A few people have asked me what I mean by a "comfortable" level and it's difficult to answer. Many people have uncomfortably high mortgages and I think getting rid of the discomfort should take priority over funding a pension. My gut feel is that a mortgage equal to your gross salary and less than 50% of the value of the property would be comfortable.

It does seem wrong to wait until one is 40 to start a pension. But that would only be wrong if one was not saving at all. Paying off one's mortgage is a great form of tax-efficient saving.

If I live in my home mortgage free, should I remortgage to contribute to a pension scheme? Probably no, at 4.5% mortgage rate. Probably yes at 1.15% cheap tracker.

If I have a mortgage of three times my salary, should I focus on paying it down to a comfortable level? Absolutely.

Duke, would you like to crunch some numbers comparing paying off a mortgage in full before starting a pension with starting a pension while still having a comfortable mortgage?

Brendan Burgess said:

Duke, would you like to crunch some numbers comparing paying off a mortgage in full before starting a pension with starting a pension while still having a comfortable mortgage?

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Is that an assignment Boss?

Let's park Tracker Mortgages - don't ever pay down a Tracker Mortgage before taking out a pension. But if you have both your pension secure (public servants) and you have surplus cash earning .5% maybe even a TM should be paid down - though state savings still probably justify keeping a TM geared position.

So what about paying down a conventional mortgage before taking out a pension? I think the cold calculus points to the former. Let's say your mortgage is costing 5%. That means that paying down your mortgage earns 5% tax free and guaranteed. So ask yourself, if you had a few bob to invest would you invest in equities or would you invest in a deposit which guaranteed you a 5% tax free return? Easy call, don't you think?

A pension plan will give you access to equity investment. Let's say we believe in the equity risk premium. We might say then that we expect equities on average to beat fixed interest by 3%, so let's say that is about 5% but with that risk (upside as well as downside of course). The 5% guaranteed seems still to be a winner. When you consider that charges (including the ongoing levy) will consume at least 1% of your fund which is very high in today's low inflation/low interest rate environment, the scales get tilted even more towards paying off the mortgage. Yes, there are tax breaks with the pension arrangement but these are not as great as imagined and they come with the downside that you lose considerable flexibility.

Conclusion - pay down your conventional mortgage first in all circumstances.

Duke of Marmalade said:

Is that an assignment Boss?



Conclusion - pay down your conventional mortgage first in all circumstances.

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.

Well done! 10/10!

It's an amazing conclusion. I get criticized for suggesting that mortgages should be paid down to a comfortable level.

To put a bit more meat onto Duke's bones, I ran a few calculations

Assumptions:


Variable rate average: 5%
Net pension return: 4.5%
Term: 25 years

Mortgage of €235,980

Spare gross cash per month: €1,000

Mortgage Repayment €1,374 per month paid for full term

€1,000 put into pension, monthly for 25 years - €552,998

Divert €1,000 from pension into mortgage. Tax at 54% = €460 extra into mortgage.
Mortgage paid off in 15.33 years

Put the €1,000 into your mortgage instead, then when the mortgage is paid off, put the €1,000 and the mortgage amount into pension (€3,987 pm) for 9.66 years = €571,937.

In other words, you will have a higher pension in the end, if you pay off your mortgage before starting a pension.


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

SBarrett said:

To put a bit more meat onto Duke's bones, I ran a few calculations

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Good stuff SB! Boss another 10/10?

And there is no tax advantage in contributing now rather than deferring. What was confusing me was the possibility that you wouldn't save at all for your pension but so long as you eventually do accumulate the same amount (or more) in a pension fund you will enjoy the same tax arbitrage. BTW thinking along these lines makes me recognise that it would be really quite unwise for someone only getting standard rate relief to prioritise the pension over repayment of a standard mortgage.

This is all a bit disturbing. Is there any case to be made for the defence? The obvious case is to argue that we are underplaying the potential returns in a pension plan. Maybe so, but it is for the defence to argue its case. The prosecution (that's you Boss) cannot in any way be criticised for the case they are making.

Another argument for the defence is that by spreading equity investment over a longer period there is less likelihood of getting the timing wrong - weakish in my view.

Of course, we must not dismiss individual preferences. The financial math leaves the prosecution case unimpeachable. Yet by deferring equity investment you might miss some big bounce over the next few years. Only a charlatan would actually predict such a bounce. Nonetheless some folk may have a greater fear of missing a bounce than doing the strictly correct thing according to the financial math.


How many financial advisors make this position as clear as this to their clients? In the end of the day, no matter what the good intentions, if there is conflict of interest it is very hard to ensure that people get unbiased advice. The bias may be unintentional but if there is not a will to tease everything out logically the bias will remain uncovered.

There is definitely scope for an opinion piece here. Boss or maybe SB, why not try Niall Brady of the ST?

Duke

The problem with the figures are that they use very stable assumptions. In reality, it's not like that. A fund can make 50% in year 1 and lose 50% in year 2. The average return over 2 years is 0%. Yet the €100 I invested is only worth €75.

My job as an advisor is to strike a balance for each of my clients. I do this by finding out what is important to them and what they worry about. A lot of clients would worry about leaving their pension funding until the last 10 years.

You do expose yourself to greater market risk by concentrating your investment into a shorter period of time. It wasn't too long ago that we were bombarded with stats of 0% return over 10 year investment term. It is not a weakish argument that spreading your investment over a longer period reduces the risk exposure. You may also reduce the potential returns but that is the trade off.

As this argument is based on unknown future returns, it is impossible to say that one approach is better than an other.


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

SBarrett said:

As this argument is based on unknown future returns, it is impossible to say that one approach is better than an other.

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It is indeed but what strikes me is that many people are not getting the right perspective in making their decision. And this is even accepting that most financial advisors act in good faith. But few would have the grasp of the true dynamics that you have. Here are some very stark misconceptions:

1) Deferring taking out a pension is foregoing tax relief - it is not, as your example shows; you make up for it when it comes to the deferred pension phase.

2) Pensions are so well tax subsidised they must always beat any alternative.

3) It is not rocket science but, as the Boss has found out, people do find it difficult to grasp that paying down a mortgage is exactly the same as saving, compound interest and all.

Here is the picture that should be put to a person seeking advice in this area:

"Say, you had a sum of money to invest and you had a choice of a tax free return absolutely guaranteed of 5% (note the absolute guarantee, banks don't default on mortgages!) or of investing in an equity fund, similarly tax free but subject to charges of over 1% p.a., which would you prefer?"

Of course, it would also be necessary to give a sense of how the equity fund might perform - that is where it gets real tricky.

I did ignore funding limits for personal pensions in my example. In fact, just checking them now, the second scenario is outside the maximum tax relievable limit of €46,000. You would have to be earning at least €115,000 to hit those limits. So, for a lot of people, being able to put that level of money into a pension for 10 years is not a runner as the Revenue won't allow them to claim tax relief on the premiums.

When advising clients, you have to ask them what is important to them. What financial problem that they have takes priority and lets solve it. It is rare that someone stops paying into a pension to pay down a mortgage unless they have a lot of debt and it will carry into their retirement.


Steven
http://www.bluewaterfp.ie

SBarrett said:

I did ignore funding limits for personal pensions in my example. In fact, just checking them now, the second scenario is outside the maximum tax relievable limit of €46,000. You would have to be earning at least €115,000 to hit those limits.

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Good spot! Fairly complicated picture all round.

Copied from another thread on the issue

Re-reading this thread, the conclusion seems to me to be principally predicated on the basis that as the Duke put it there is "no tax advantage in contributing now rather than deferring."

In the interests of debate, I'll give some counter arguments.....

This premise (of there being no tax gain) may be valid in specific circumstances but much less likely to be true (if at all) in any of the following situations:

- you die
- you get sick
- you become unemployed
- your income reduces
- your income increases (say above the cap)
- your income is already above the cap
- the rate of tax relief reduces
- alternative tax efficient investments become available in the future
- you wish to early retire, etc., etc.

Accordingly, whilst not without merit, the absolute nature of the Duke's conclusion needs to be challenged as does the tone of Brendan's "And even if you found a good advisor, it's likely that they would sell you a pension."!!!!

Well all I can say is its not as simple an equation as whether to choose to leave money in a deposit account or pay off the mortage!

Some variables-

- has the analysis in the other thread included the fact that there is tax relief on mortgage interest, or that your pension is taxed when you get paid it, or the availability of the lump sum tax free?

- I note that the tax relief available on pension contributions increases as you get older though I'm not sure how to incorporate this into my decision (I'm 35 now)

- another factor for me is that my earnings fluctuate, in a good year I could conceivably make 50% more than a bad year, given that there may be years when I have less of a chance to claim the tax relief (because I have less of a liability) maybe I should pay more in those years to the pension (obv I will have less money available in those years though, but the point is that at the moment, having neither been paying off the mortgage or paying into a pension I have a lot more in the bank than I would be able to save in a given year

- a friend made a good point to me in relation to the importance of understanding how much money I'll need on retirement, I would think 30k a year would be sufficient for me to live comfortably if I was 70 today and retiring. Maybe I should also factor this in vis a vis what total pension size I want, whether I can achieve that at a later point in life and instead pay off the mortgage now?

- also there are the known unknowns - will the govt change the tax regime in relation to pensions? Will the limits change etc?

Also the stat from Brendan's article that the average person getting a mortgage now has a deposit of 10% of value of the home, and that different LTV mortgages have different rates should be factored in. If I envisage buying a home for say 600k in 6 years time then I need 60k in the bank and disposable in 6 years time, and I may benefit from being able to get a better rate on what will undoubtedly be a much bigger mortgage than the one I have now.

The more you know the more confusing it gets!

As it happens I have a relative who used to work in pensions so I might bounce some ideas off him.

Two other factors which have occurred to me so far

1 - there is much speculation that the tax relief available on pensions so far will be reduced in the next few years, ergo I should make use of it while I can

2 - in the present structure in later years I can claim much higher tax relief in that I am allowed pay a higher percentage of my income into the fund, if I was to pay off the mortgage earlier I would have more disposable income in those years to avail of the higher relief

I have moved the bits about tracker mortgages from the above posts, so that they focus on SVR mortgages.

It's pretty conclusive. It's far better to pay into a pension scheme, rather than to pay off a tracker mortgage early.

Duke:

Let's park Tracker Mortgages - don't ever pay down a Tracker Mortgage before taking out a pension. But if you have both your pension secure (public servants) and you have surplus cash earning .5% maybe even a TM should be paid down - though state savings still probably justify keeping a TM geared position.

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SBarrett:

Scenario 1 - Tracker mortgage
Tracker rate: 2%
Mortgage Repayment €1,000 per month paid for full term
€1,000 put into pension, monthly for 25 years - €552,998

Divert €1,000 from pension into mortgage. Tax at 54% = €460 extra into mortgage.
Mortgage paid off in 15.66 years
Pay mortgage amount plus €1,000 into pension (€3,174 pm) for 9.33 years = €435,955.

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Duke and S

I had meant to come back to this very important issue, but didn't get around to it.

I have moved the posts out of the thread they were in to focus on the issue.
I have moved the tracker stuff to a separate post to simplify the discussion.
I have started summarising the conclusion in the first post. (I am not happy with this yet)
I will do a Devil's Advocate post

SBarrett said:

Divert €1,000 from pension into mortgage. Tax at 54% = €460 extra into mortgage.
Mortgage paid off in 15.33 years

Put the €1,000 into your mortgage instead, then when the mortgage is paid off, put the €1,000 and the mortgage amount into pension (€3,987 pm) for 9.66 years = €571,937.

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Hi S

Can I just check these figures?

If I take out €1,000 from my gross salary as pay, I will pay either 52% tax on it if I am an employee, and 55% if I am self-employed. (54% is a fair average)

If I allocate €1,000 of my gross pay for a pension contribution...
I will pay 11% prsi and USC leaving €890 to contribute to the pension.

If I am right, I think this needs to be corrected to €890 a year

€1,000 put into pension, monthly for 25 years - €552,998

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And likewise, after I pay off my mortgage, the figure would need to be reduced as well.

Brendan

The problem of the limits on pension contributions

If there were no limits on pension contributions and if I was guaranteed a taxable income until the age of 65, then paying off the mortgage in full would be the right strategy. There would be plenty of time to start a pension after the mortgage is paid off and I can, of course, pay the money saved by not paying the mortgage into the pension fund.

However, if I leave it too late, I face two risks
1) I run into the pension limits
2) I might not have a taxable income against which to make pension contributions
Lets say I pay off my mortgage in full and start contributing to a pension at age 50, when my salary is €60,000. If I work to 65, my total contributions would be around €315,000.

But, if I lose my job at 60, that would fall to about €200,000.

I would have my mortgage paid off, and I would have surplus cash, but I would not be able to put this cash, tax efficiently, into a pension fund.

I am coming to the rough rule of thumb that one should pay off one's mortgage instead of contributing to a pension fund up to the age of 40. If the mortgage at that stage is at a comfortable level, then one should make maximimise the pension contributions ahead of making further capital repayments on the mortgage.

Brendan

It's good that you have moved from the almost absolute position of the earlier debate. I think the comments I made in the earlier debate need to be incorporated into any fuller commentary on the issue.

Hi Elac

I had not seen those points in the other thread. I have copied them and the responses here to raise their prominence.

Brendan

elacsaplau said:

This premise (of there being no tax gain) may be valid in specific circumstances but much less likely to be true (if at all) in any of the following situations:

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- you die

Assume you are married. Will your spouse be better off if you had contributed to a pension fund instead of paying off your mortgage?



- you get sick/ - you become unemployed/- your income reduces

I think all three of these are the same?

If my income reduces temporarily, I would be much happier to have a smaller mortgage.

If my income in later years, is reduced, I may not be able to contribute enough to a pension fund.


- your income increases (say above the cap)/ - your income is already above the cap

I don't follow this argument? If my income increases beyond the €115,000, then I can make the maximum contribution.

I should not fund a pension beyond €800,000 anyway.

- the rate of tax relief reduces

If the rate is reduced from the marginal rate to,say 30%, as has been suggested, then there would be no point in a high rate tax payer contributing to a pension fund.

And this is part of the problem of pension planning. If the €200,000 tax-free lump sum is reduced further, you would be glad you had paid off your mortgage and not wasted your money on contributing to a pension.

- alternative tax efficient investments become available in the future

Is this not an argument for paying off your mortgage? If I have paid off my mortgage by age 50, I can choose between contributing to a pension and some alternative tax efficient investment. If I have already put my money in a pension fund, I can't choose between paying off my mortgage and the tax-efficient alternative.

- you wish to early retire, etc., etc.

This is the big argument which swung it for me. You may not wish to retire early, but it may be forced on you at age 55. You will have lost out on the last 10 years of tax-efficient contributions.

Accordingly, whilst not without merit, the absolute nature of the Duke's conclusion needs to be challenged as does the tone of Brendan's "And even if you found a good advisor, it's likely that they would sell you a pension."!!!!

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That is the crowd wisdom of Askaboutmoney being superior to any individual's point of view.