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Why you need a pension fund (or retirement annuity) even if you own a house

5 June 2015 10:26 AM

Many people falsely believe they do not have to save for retirement because they own the home they live in.

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You don’t have a pension fund or a retirement annuity, but you’re not worried because you own a large house in a good area.

Home is where the heart is — but it will not fund the retirement you want.

Here’s why…

The value of your house is theoretical

You don’t really know what your house is worth until you sell it and it’s impossible to predict what the property market will look like when you need or want to retire.

What if there’s a massive property bust? What if you are forced to sell due to, for example, a divorce? What if, by the time you retire, your leafy neighbourhood has become a crime hotspot? What if your formerly quiet area turns into a Business District?

Businesses close down, jobs are lost, cities and neighbourhoods change... Yet you’re hoping it’ll all be fine at the time when you sell? You cannot ever know for sure what the future holds. You are betting the good life on your home’s future value, which is conjecture at best.

You still have to live somewhere and most people struggle to downsize

It’ll cost you a pretty penny to sell your house and then what? You still have to live somewhere! Whatever you tell yourself now, it will probably be harder to downscale than you think. Many people try and most either fail or experience the process as a hardship.

You sell your huge house and buy a small one, and the difference is supposed to fund your retirement. How much will that difference be? Would you have to uproot and move to a cheaper area? Again, there are a lot of uncertainties.

You’ve put all your eggs in one basket

On some level you probably understand the concept of “not putting all your eggs into one basket”. Yet, by relying on your home to fund your retirement, this is exactly what you’re doing.

Having a pension fund or retirement annuity gives you the opportunity to diversify your investments between the various asset classes (shares, property, bonds and cash) as well as providing diversification benefits within each asset class (you’ll own shares in various companies, you’ll own shares in various properties, etc.). An investment in a residential property gives you exposure to a single asset within a single asset class.

Diversification is central to a successful investment plan. It is therefore not recommended, and extremely risky, to only invest in a single property.

Maintenance costs

The costs of owning property is open ended and will depend on a variety of factors, many of them unknown at the time of purchase. These include but aren’t limited to maintenance costs, massive amounts paid in interest over the duration of the loan, rates, taxes, insurance, etc…

The cost of owning property is significantly greater than the costs associated with, for example, a retirement annuity. You also know upfront how much it’ll set you back because, unlike property, costs are set in stone.

You’ve missed out on a lifetime of tax breaks that comes with pension contributions

The government taxes you for owning property, but pays you to invest in a pension fund or retirement annuity.

Currently up to 15 percent of your gross income is tax deductible if you invest it in a retirement annuity. If you contribute more than that you may claim the excess amount in future years and you may add excess contributions to the tax-free portion of any lump sum you receive.

This is not peanuts; it’s a fortune! The government is paying you crazy money to save for your own retirement. By relying only on your property to fund your retirement you’re saying “no thank you” to the mother of all free lunches.

You start over if you go bankrupt

If you should go bankrupt you'll have to sell your house (or the bank will do it for you) in order to pay your creditors.

If you had a retirement annuity you would’ve been completely protected against them. Your pension plan would be 100 percent intact and you would not lose a cent. This makes a retirement annuity especially advantageous to business owners.

The long-term returns of property are not great

Whatever you believe about your home's ability to fund your retirement, the fact is that residential property attains much lower returns than equities (though with less volatility) over longer terms.

According to the ABSA house price index, residential property lagged inflation for 16 years between 1986 and 2002. In other words, an investment in property would have lost you money. On the other hand, an investment in equities during this period outperformed property by a whopping 66 percent!

Then came the biggest property boom in South Africa's history. For five years property returned close to 20 percent, on average. This performance seems awesome, until you consider that equities returned 19.1 percent over the same period.

According to Matthew de Wet, Head of Investments at Nedgroup Investment, cash (i.e. money market investments) outperformed property, on average, by 0.5 percent per year since 1966.

A fascinating study by Piet Eichholtz, entitled The Herengracht Index, lends further weight to this argument. The Herengracht Index is an ultra-long-term study of the prices of property in the Herengracht district of Amsterdam. Records dating back to 1628 give us nearly 400 years of data to work with.

The houses on the Herengracht are well suited to a long-term study, because they have largely remained unchanged (although very well maintained) over the period in question. The Herengracht area has preserved its status as the finest area in Amsterdam in which to reside. This is important, because it means we are analysing an area that has retained its value relative to properties in other areas.

It is remarkable that real (i.e. taking inflation into account) house-price growth has averaged only 0.5 percent per year over the entire period. The results are fairly consistent over each century; the lowest real growth of -0.2 percent per year being in the 18th and 20th centuries and the highest real growth of 1.3 percent per annum being in the 17th century. Over shorter periods of time the real growth rate varied far more dramatically, with real price changes in excess of 50 percent over any 10-year period common.

Conclusion

Your large, paid-off house in a leafy neighbourhood is not a pension plan and risking the life you want for yourself on a single asset can never be a good idea.


This article first appeared on CapeTalk : Why you need a pension fund (or retirement annuity) even if you own a house


5 June 2015 10:26 AM

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