You’ll find no shortage of broker’s websites espousing the benefits of property investing in a pension and many are more than happy to facilitate the transaction for clients that request it.
Not doing something that almost everyone else seems happy to do is another reason why we stand out in the Irish Financial Adviser market so we set out below our reasons why we don’t recommend that most people should hold residential property in their pensions.
There are two ways you can invest in property:
- Directly – by buying a property as an investment (buy to let)
- Indirectly – by investing your pension in a property fund
Buying a property for investment
You will need to have either a large sum of money, or you will have to borrow, to invest directly in property. There are two main ways you can get a return from property investment including:
- Rental income
- Capital growth if the value of the property rises
With property investment you are more vulnerable to potential risks, such as a downturn in the property market. But you may also face risks such as:
- Rental income may be less than you expected and is not guaranteed. There will also be times when the property has no tenant
- Increased mortgage repayments if you borrow money to buy the property and interest rates rise
- Falling property values, which could lead to negative equity
- Immediate access to your money may be difficult (liquidity)
- Selling the property may be difficult, time consuming and incur additional expense
- You may lose money if you are forced to sell the property quickly
- Difficulties in managing your investment property
- How do you pay Death Benefits to your Spouse or Civil Partner?
Investing in a property fund
You can also invest indirectly in property through a property fund. These funds typically invest in commercial, retail and industrial property.
In Ireland you can invest in commercial property through
- unit-linked funds from an Insurance Company or;
- listed funds such as an Exchange Traded Fund
We don't recommend unit-linked property funds because the value of these is a matter of opinion of the valuer and they are typically priced less frequently.
This gives the appearance that they are less risky than they really are and are prone to being "gated" whereby the insurance company will not allow withdrawals with less then six months notice
Our preference for including Real Estate in a pension is therefore via a large, liquid, daily priced global property fund from one of the major investment managers such as Blackrock or Vanguard. These are generally less expensive and better diversified than the alternatives generally available to an Irish Pension investor.
Our detailed analysis of property risk and returns over the last 50 years can be found here
For the same reasons that we don’t recommend that most private individuals hold individual stocks in a single company (especially their employer), diversification is objectively the single biggest reason not to invest in residential property.
Most of us have three significant assets:
Our Human Capital
Our human capital is our ability to earn a wage or if we are company directors, the value of our own business. This is best protected against the most likely and damaging risk by a Permanent Health Insurance Policy which pays out an income if we are unable to work due to illness or disability.
Most of us buy our home with the assistance of a mortgage and we protect ourselves and our families by arranging Life Insurance to clear the loan in the event of our death and we arrange buildings and contents insurance to protect the property against risks like fire and floods.
For many of us, our pension also represents a substantial asset.
Think for a moment about how most of us are measured and prudent when we think about the risks associated with our home or our income.
This same sense of prudence is reflected when investing through the concept of diversification. Not putting all your eggs in one basket is the closest thing we have in investing to a "free lunch"
Considerable guidance is available on the subject in particular to Pension Trustees
In the U.K., for example, the rules on investing in property in pensions are very strict, and you can't buy individual residential properties to hold within your pension. If you put a property into a Pension that HMRC deems to be residential you will be hit with a big tax bill of at least 55% of the investment
This is a new EU directive applicable to occupational pensions.
Under this directive, the pension scheme’s assets must be predominantly invested in regulated markets, therefore direct property investments will be restricted. In addition, borrowing will only be allowable for liquidity purposes and only on a temporary basis which will affect a scheme’s ability to borrow for direct property.
Note that other pension structures like PRSAs and Buy out Bonds are not subject to the IORP II directive.
Trustee Investment Act (2000)
For many years UK trustees have had to take care in investment matters
“as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide”
Court of Appeal, re Whiteley 1886
This was further codified in the Trustee Investment Act 2000 with the following
Standard Investment Criteria
a) The suitability of the trust investments
b) The need for diversification
Suitability relates to both the type of investment proposed and the features including its tax treatment.
As a component of suitability, express account must be taken of the size and risk profile of the investment and attention is drawn to the desirability of diversification between complementary investments as a means of risk control.
Trustees must in addition seek to achieve a balance between income and growth that may be a factor of the trust in question.
Similar legislation in the USA
Prudent investment rule 1992
Five Principles of Prudence
- Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
- Risk and return are so directly related that trustees have a duty to analyse and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.
- Trustees have a duty to avoid fees, transaction costs and other expenses that are not justified by the needs and realistic objectives of the trust’s investment program.
- The fiduciary duty of impartiality requires a balancing of the elements of return between production of current income and the protection of purchasing power.
- Trustees may have a duty as well as the authority to delegate as prudent investors would.
“Restatement of the Law, Trust, Prudent Investor Rule” published in the USA in 1992
Clearly, Internationally, the weight of legislative and judicial opinion is against highly concentrated, undiversified investments such as residential property and Trustees and Financial Advisers who ignore their Fiduciary responsibilities are sailing close to the wind.
So this begs the question, if professional advisers know that residential property in a pension represents a poor choice for most people, why are they happy to facilitate it?
The answer is, of course, the insidious conflict of interest posed by commission. A commission-based broker is being paid a commission by the product provider to facilitate a transaction.
Whereas a fee-only adviser, such as Global Wealth, is being paid by their clients to exercise professional judgment and act in the best interests of their client.
I am diversified, I’ve got three properties in my pension.
This isn’t diversification. Diversification means holding different assets that can be expected to perform in different ways to different economic conditions. Holding multiple properties isn’t diversification.
In a pension portfolio, Stocks are diversified with Bonds because Bonds can reasonably be expected to perform differently due to a low correlation with Stocks. You simply don't get this from multiple property investments
Evidence from practising investors and academics alike points to an undeniable conclusion: expected investment returns are related to exposure to investment risk. Gain is rarely accomplished without taking a chance, but not all risk-taking is rewarded.When considering an appropriate asset allocation strategy, Trustees should also take account of such issues as:
(a) the nature of the liabilities of the trust,
(b) an appropriate diversification of investments, including appropriate diversification of credit and counterparty risks, and
(c) the appropriate liquidity of investments especially where capital is to be advanced to beneficiaries.
Successful investing of Trust capital means not only capturing risks that generate expected return but reducing risks that do not. Avoidable risks include holding too few securities, betting on individual countries or specific industries, following market predictions, and speculating on "information". To all of these simple diversification is the antidote. It washes away the random fortunes of individual stocks and positions a portfolio to capture the returns of broad economic forces.
I only have to put down 50% the rest is borrowed
Gearing or leverage is a wonderful tool in investing, but it is a double edged sword. It’s great when things are going up, but it magnifies the losses when things are going down.
What Is Leverage?
Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets.
Leverage is the use of debt (borrowed capital) in order to undertake investment. The result is to multiply the potential returns from an investment. At the same time, leverage will also multiply the potential downside risk in case the investment does not work out. When one refers to a property as "highly leveraged," it means that item has more debt than equity.
The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.
Disadvantages of Leverage
Leverage is a multi-faceted, complex tool. The theory sounds great, and in reality, the use of leverage can be profitable, but the reverse is also true. Leverage magnifies both gains and losses. If an investor uses leverage to make an investment and the investment moves against the investor, their loss is much greater than it would've been if they have not leveraged the investment.
For this reason, leverage should generally be avoided by pension investors.