Many people are attracted to the idea of being a landlord. The popular book, Rich Dad Poor Dad, by Robert Kiyosaki captured many imaginations with the idea of the ordinary investor building a property portfolio - generating a passive “snowballing” income which could even sustain retirement lifestyles.

Of course, Kiyosaki’s approach is not the only way to use property to build a retirement income. Yet property, as an asset class, does differ from strategies which focus more on pensions (e.g. containing shares and/or bonds). This raises the question - where should British people concentrate their attention with their retirement goals? Should they invest in a pension or property? Does the answer involve some combination of both?

The utility of an owned home

In the UK, it’s easy for this discussion to lean towards debates about buy to let (BTL) versus pensions. This is important, but it’s also crucial to consider the role of your home in retirement, not just the additional properties you may own.

In particular, do you plan to rent or own your home outright?

In general, financial planners encourage those with mortgages to pay these off before retiring. This brings many benefits such as less need to worry about how interest rates may affect your repayments. By settling your mortgage, you remove a large monthly expense which would otherwise need to be covered by your pension (or other income sources).

By contrast, retired tenants have to live with the uncertainty that their rent may rise in the future. Moreover, they potentially need more savings to cover the extra cost of 10, 20 or more years of rent across their retirement. This is not to say that it is never a good idea to rent in retirement, but it brings additional financial liabilities which need to be addressed.

As such, the answer to the great “property vs. pension” debate partly lies in your circumstances and stage of life. For instance, do you have 15 years left on your mortgage but hope to retire in 10 years? If so, you may wish to focus more attention on making overpayments to try and completely settle the debt before your target retirement date

Why the economy matters

When considering overpayments on your mortgage, one factor to consider is the wider interest rate environment. The Bank of England (BoE) base rate has a big impact on the rates that customer-facing lenders impose on products like savings accounts and mortgages. Therefore, the higher interest rates are, the more interest certain customers could save on their home loan (e.g. those on a variable-rate deal).

In the years between the 2008-9 Financial Crisis and the start of the pandemic, UK interest rates were quite low. Indeed, in 2020 the base rate stood at an historic low of 0.10%. This meant that overpaying a mortgage was generally seen as inferior to investing in shares and/or bonds. This is because the latter offered higher potential returns than the potential interest savings from overpaying a mortgage.

In 2023, however, there is now more debate about whether overpaying is worthwhile due to the rise in interest rates. At the time of writing (November 2023), the base rate stands at 5.25% and could still increase even more as the BoE struggles to control inflation. As a result, the average 5-year fixed mortgage deal in October 2023 was 5.35%; considerably higher compared to a few years ago. Indeed, many people coming up to the end of their existing fixed-rate deal are facing a significant increase in their monthly repayments as they enter a very different mortgage market than before.

As a general rule, the investment markets are a strong option for those looking to build long-term wealth. This can be done very effectively via a pension due to its tax advantages. However, when interest rates are high, this can add greater incentive to consider mortgage overpayments, helping to mitigate your liabilities. Just be mindful of any conditions that your lender may impose. For instance, many cap overpayments each year at 10% of the outstanding mortgage debt. If your overpayments exceed the lender’s limits, they may impose penalties.

Properties, pensions and the matter of tax

From an inheritance tax (IHT) perspective, your main home will likely have a key place in your estate plan. In 2023-24, an individual can pass down up to £325,000 to beneficiaries without facing the 40% IHT charge on their assets. If he/she leaves the family home to “direct descendants” such as children, moreover, then the Main Residence Nil Rate Band “extends” their IHT-free allowance by up to £175,000.

Therefore, building equity in your home can be more IHT-efficient than building wealth in a general investment account (GIA) or an ISA, where the assets are perhaps more likely to exceed your IHT-free threshold. Pensions, however, are still a powerful tool. In 2023-24, pension pots (i.e. “defined contribution” pensions) can be handed down to beneficiaries completely without IHT. Given that there is currently no maximum limit on how much an individual can now save into pensions without incurring a tax charge (due to the abolition of the Lifetime Allowance charge), pensions are arguably now even more superior to property from an IHT perspective.

It is also worth noting that additional properties - such as BTLs - can be difficult to shield from the taxman, both during the investor’s lifetime and upon death. Rental income from tenants will fall under Income Tax. For a Higher Rate taxpayer, this can be quite punitive at the 40% rate (or 42% in Scotland).

One option is to incorporate your property portfolio to try and reduce the capital gains tax burden and make rental income subject to corporation tax (which is lower than the Higher Rate on Income Tax). However, this is a complex process and could have significant knock-on effects to other parts of your financial plan.

Make sure you take financial advice to gain the clarity, information and peace of mind you need to make the best decisions. Get in touch with the team team today to get started.

*the above is provided for information only. It does not take account of individual circumstances and should not be regarded as advice.