Key Post Should a person in their 20s or 30s contribute to a pension?

[Brendan Burgess]

Take a 40-something with a 50% LTV on a 2.8% rate, mortgage payments of 10% of net income.

I would not disagree with you that someone who owns their own house with a low mortgage rate, low LTV and 10% of net income should be maxing their pension.

Brendan

 

[Brendan Burgess]

The whole nature of compound interest is that the earlier you start, the bigger the eventual return.

But you are starting at the same time!

I have pointed out that starting a pension is better than squandering it. But for someone young, buying a house and having a comfortable mortgage is a higher priority.

Brendan

 

[NoRegretsCoyote]

But you are starting at the same time!

I have pointed out that starting a pension is better than squandering it. But for someone young, buying a house and having a comfortable mortgage is a higher priority.

But over the long run equity returns generally outstrip real estate returns.

Anyway, you have made poor investment decisions if at 65 you feel that your pension pot is too small but your house is too big.

 

[Brendan Burgess]

you have made poor investment decisions if at 65 you feel that your pension pot is too small but your house is too big.

But you are making a false choice here.

I am all for big pension pots. The point of this post is that one should get the guaranteed compound return of the paying down one's mortgage to a comfortable level in the early years. Then you will have more capacity for making bigger pension contributions in later years because you won't have mortgage payments to make.

Even if I had the artificial choice of a House worth €1m and a pension fund of €500k or a house worth €500k and pension fund of €1m. I would choose the bigger house. I could trade down and have €500k of savings outside a pension pot instead of inside one.

Brendan

 

[NoRegretsCoyote]

Even if I had the artificial choice of a House worth €1m and a pension fund of €500k or a house worth €500k and pension fund of €1m. I would choose the bigger house. I could trade down and have €500k of savings outside a pension pot instead of inside one.

Brendan

But that is not the choice. If you start at 25 and put more toward your pension and less toward your house your overall wealth at 65 is likely to be bigger. This is because pension investment has tax advantages and generally delivers better returns.

The choice is more likely to be:
1) House worth €800k and pension pot of €700k
2) House worth €600k and pension pot of €1.1m

Everyone's preferences are different, but I'd prefer Option 2).

 

[Brendan Burgess]

If you start at 25 and put more toward your pension and less toward your house your overall wealth at 65 is likely to be bigger.

You would have to make a lot of assumptions over a period of 40 years to arrive at that result. And the gap could be even wider than you suggest.
One of the ones which would be difficult to factor in is that by buying a house with a mortgage earlier than you would otherwise be doing, you would be getting the leveraged returns on the property. You would also be saving the rent which would be less than the cost of the mortgage.

And, of course, the tax rules would have to remain the same.

Brendan

 

[NoRegretsCoyote]

You would have to make a lot of assumptions over a period of 40 years to arrive at that result.

All you have to assume is that a higher rate of return results in a higher amount over the period.

Anyway thanks but I'm out. No one has argued that compound interest isn't an extremely powerful force

 

[Homer]

Interesting post Brendan.

In general, I agree with most of what you say, but I have a couple of comments.

Firstly, you state that the tax regime will change before someone in their 20s or 30s retires. While I agree that it is extremely likely that there will be some (if not several) changes, I'm not sure that you should be making an absolute statement about this.

Secondly, you recommend that individuals contribute an amount equal to the employer contributions. While I understand the principle of what you're saying, the key issue is to at least make contributions up to the maximum limit that will attract additional employer contributions. Typically, this will be on a 1 for 1 basis, but I have seen other ratios (e.g. 1 for 2) and many plans have a basic employer contribution that is higher than the minimum required employee contribution.

I agree with the broad thrust of what you're saying about house purchase versus pension contributions. Regarding the power of compound interest, this applies to both house prices and to pension contributions, but will have a greater overall financial impact for someone who purchases their house at a young age rather than maximising their pension contribution. The reason for this is that the extra years' growth will apply to the entire value of the house, while it will only apply to the relatively small proportion of your overall pension fund that you have built up by (say) age 30.

Even if you assume that house prices will grow at a lower rate than equity returns, the fact that the entire value of the house benefits from this growth and the fact that capital gains on your principal private residence are totally tax free hugely tilts the balance in favour of early house purchase, in my opinion. And that's even before you take the saving in rent into account. Of course, this assumes that you get your timing right and don't purchase just before a huge slump in the housing market. But I'm no better than anyone else in predicting when this might happen.

Having said all that, I think it is a good idea for everyone who is in the tax net to start contributing to a pension fund as early as possible, even if it's just to establish the habit of doing so and to overcome the inertia factor. But, as you say, if I was my marginal tax rate was 20%, I would only contribute up to the limit that will attract employer matching contributions, or just pay a minimum amount if there is no matching contribution.

 

[Sarenco]

I think we may be in danger of talking at cross-purposes.

For the avoidance of doubt, I think it is reasonable for somebody in their 20s/30s not to make unmatched pension contributions where:-

• They are saving for a deposit for a property;
• The contributions would only receive tax relief at 20%; or
• They are carrying (or are in danger of incurring) expensive (non-mortgage) debt to meet day-to-day expenses.

However, in general, I think it makes more sense to max out tax-relieved pension contributions in priority to paying down a mortgage ahead of schedule.

 

[NoRegretsCoyote]

I agree with the broad thrust of what you're saying about house purchase versus pension contributions. Regarding the power of compound interest, this applies to both house prices and to pension contributions

No.

For compound interest to work you need to re-invest the income stream generated by the asset.

But much of the return from housing is not re-invested, because the income stream is the benefit you get from living in the house.

The only (financial) return you get is the capital gain.

 

[Brendan Burgess]

No.

For compound interest to work you need to re-invest the income stream generated by the asset.

So house prices increase by "simple interest" rather than by "compound interest"?

Brendan

 

[Homer]

Sorry, that's just not true. Let's assume the income is 2% and the capital growth is 5%. If you reinvest the income, your total return is 7%. So after 40 years you have (1.07)^40 times your original investment if you reinvest the income and (1.05)^40 times if you don't reinvest the income.

 

[Brendan Burgess]

For the avoidance of doubt, I think it is reasonable for somebody in their 20s/30s not to make unmatched pension contributions where:-

• They are saving for a deposit for a property;
• The contributions would only receive tax relief at 20%; or
• They are carrying (or are in danger of incurring) expensive (non-mortgage) debt to meet day-to-day expenses.

Sarenco

That is a really interesting post.

It seems that we are in about 80% or 90% agreement.

We agree that contributing to a pension is usually the best way of saving for the long-term, but there are occasions when people should not do so.

And this strategy would shock a lot of people who have been told for years that they can never be too young to start a pension and the earlier you start the richer you will be.

So our only point of disagreement, for the cohort in their 20s and 30s is whether they should max out their pension contributions or pay down their mortgage.

Having dealt with so many people in deep mortgage distress, the risks of high mortgages go well beyond the financial arithmetic. Which is why I say paying down an uncomfortably high mortgage is a higher priority.

So, we probably aren't that far apart on that either, as my conclusion is:

So maybe you should strike a balance between pension contributions and overpaying your mortgage

 

[Sarenco]

So our only point of disagreement, for the cohort in their 20s and 30s is whether they should max out their pension contributions or pay down their mortgage.

That's probably fair Brendan.

On the mortgage distress issue, I would note:
- By international standards, our system is exceptionally accommodating towards defaulting home loan borrowers; and
- Pension funds are essentially protected in any bankruptcy proceedings.

One of the great advantages of people in their 20s/30s is their ability to leverage their substantial human capital.

 

[Brendan Burgess]

- Pension funds are essentially protected in any bankruptcy proceedings.

Actually, I had made a note of that when drafting the first post. If you are in no-hope mortgage distress should you max your pension? But I thought it such a rare event, that I did not want to complicate things and I did not want to encourage people to try to escape their debts.

Brendan

 

[Marc]

This is one of the most complex financial planning decisions given that you don't know when you are younger how your life is actually going to play out.

I saved in a pension in my 20s and I now have a significant pension fund. I'm 50 next year and can access it if I need to, which given that I have a 5 year old and a 9 year old is a distinct possibility.

Having saved in my 20s when I didn't have kids was the best financial decision I made. Because Its harder to do now even with more salary I have less disposable income.

I also bought a house, sold it and bought another one. The money I made on those two houses (with a preferential bank staff mortgage) was about half the amount I have made on the pension.

So, its not at all clear-cut what one should do. But it is clear that compound interest over a very long-time will ALWAYS tend to beat massive savings when older.

I think its important to consider where the money is coming from and also what are the alternatives you could invest in.

Let's say I'm 18 and Granny gives me my maximum CAT C exempt gift of €16,250. Let's assume I achieve average equity returns and I invest it to age 68. Let's compare that to an investment which pays exit tax at 41%. Keep everything else constant. No changes in tax rates and ignore the additional benefit of the income tax relief that I could offset against my salary when I start work.




Based on current rules, you would be looking at the following set of options in retirement (or an annuity) or some other set of rules that don't exist yet so I wouldn't get too hung up on the actual splits.



So that's just comparing the benefits of genuine tax free growth over 50 years.

Given that there is what, €3 billion in Prize Bonds currently, I think there is a fairly strong case to be made for Granny to give junior a couple of grand to supercharge his/her future....

 

[Brendan Burgess]

Hi Marc

I don't think anyone on this thread would disagree with you. If you are investing for the long-term, you should do so via a pension fund.

The only issue is whether you should defer buying a house to start a pension or defer starting a pension to buy a house.

Brendan

 

[Gordon Gekko]

Hi Brendan,

I believe that the “use it or lose it” nature of individual pension contributions is a key element of any analysis.

Take me as an example. I could stop making AVCs and pay down my mortgage more aggressively.

But the pension rules don’t allow me to catch back up in later life because I’m always capped out at X% of €115k per year.

I simply can’t get the necessary amount of money into the fund unless I start early.

Gordon

 

[Brendan Burgess]

Hi Gordon

I have acknowledged this as an issue in the post. But let's look at it in more detail.

	years	Limit	50k salary	115k salary
40s	10​	25%​	125000​	287500​
50 -54	5​	30%​	75000​	172500​
55-59	5​	35%​	87500​	201250​
60-65	6​	40%​	120000​	276000​
			407500​	937250​

Assuming someone makes no contribution at all in their 20s or 30s, so they are starting with a zero pension pot aged 40. On a €50k salary, they will be able to contribute €407k from age 40. Even if that gets a good return, it's probably unlikely to trouble the €2m limit.

But if someone is on €50k in their 50s and they still have a mortgage, they are very unlikely to be able to contribute 30% of their salary. So if they pay down their mortgage in their 20s and 30s, they will have more scope to make higher pension contributions in later years.

Someone on a salary of €115k, starting from 0 at age 40, would probably hit the €2m ceiling if they keep contributing up to age 65.

That is obviously very simplified.

• Salaries can rise and fall
• Someone could lose their job and would be able to make no contributions - not sure if that would make them glad that they had prioritised their mortgage over their pension.
• The €2m ceiling could be raised or lowered
• The contribution limits could be raised or lowered
• The whole system could be changed.

So, I think, it still argues for paying down the mortgage to a comfortable level. But I agree that if they have the mortgage down to a comfortable level, they should be using more of their allowance.

But a bigger factor for me would be the possibility of losing the chance to contribute at all at 40% because the relief might be changed to 30% for everyone.

 

[NoRegretsCoyote]

So house prices increase by "simple interest" rather than by "compound interest"?

Brendan

No. My point is that you are not re-investing the income stream from the house because the income stream is the benefit of living in it. All you get is capital gain. You can't live in your pension fund so the income is re-invested.

Suppose you buy a house today for €100k and put €100k into a pension fund and don't add to it. If house prices go up by 50% in ten years you have a house worth €150k. If the basket of equities/bonds in your pension fund goes by 50% in ten years you have a fund not just worth €150k, but more because you've been re-investing the dividends back into the fund.

Sorry, that's just not true. Let's assume the income is 2% and the capital growth is 5%. If you reinvest the income, your total return is 7%. So after 40 years you have (1.07)^40 times your original investment if you reinvest the income and (1.05)^40 times if you don't reinvest the income.

Take this to its logical conclusion. The difference between a 5% nominal return and a 7% nominal return doesn't sound huge. 7% is only 40% bigger than 5%. But over a 40-year horizon a 5% return increases your money seven times, while a 7% return increases your money 14 times, basically double!

This is the nature of compound interest.

People with a background in tax and accounting often just don't get this, being focussed on fixes to maximise things in the short term.

As soon as you have a stable income you should contribute something to a pension fund, even as little as 1%.