Key Post Compounding doesn't just work on pensions - it also works on mortgage overpayments!

Brendan Burgess said:
The advantage of contributing to a pension over making a mortgage payment is the fact that the pension fund compounds tax-free.
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This is overly misleading imo as it doesn't cover other significant financial advantages e.g. tax-relieved contributions, employer matching (not always available).

It also doesn't cover the behavioral advantages(us humans are not rational)
-folks can't spend the money in pension till retired, regardless of how tempted they are
-with a lower mortgage most people will be more tempted to increase their spending (which will reduce what's available in retirement).
-with a lower mortgage many people will be tempted to trade up, often resulting in more advice to not fund pension, but regardless ultimately resulting in asset richer cash poorer retirement. And also with less ability to help kids and grandkids (until we die).
 
I agree with your overall core point, you can benefit from power of compounding with mortgage pre/overpayments.
 
Gordon Gekko said:
I don’t agree.

Better and cheaper to frontload the contributions.
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Of course. That wasn’t my point.

@SPC100 in general equity investment is expected to outperform mortgage interest but if it was that simple ask the following questions.
Why not max your mortgage and gear your pension to the hilt?
Similarly, why not go the mortgage endowment route?
Why do banks lend at 3% when they could earn so much more in equities?
I think the answer to these questions is “risk” and there are other issues of flexibility.

On your point of maxing employer contribution, that is a no brainer.
 
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Albert Einstein allegedly once described compound interest as the “eighth wonder of the world,” saying, “he who understands it, earns it; he who doesn't, pays for it.”
 
Brendan is right…there is obviously a compounding effect with debt.

However, €1,000 into my pension versus €600 against my mortgage just isn’t a fair fight.
 
Gordon Gekko said:
It’s really important to consider the “use it or lose it” nature of pensions tax relief. If I don’t stick €28,750 into my pension fund this year, I lose that particular contribution threshold.
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I have done a few sums. Assuming €28,750 is max available for relief and that salary remains constant going forward and funds grow at 5% p.a. I get:
If the guy is 30 then amazingly by the time he is 38 his prospective* pension fund assuming he stopped contributions would be greater than €2m**. He would be advised to stop contributing immediately and in fact he has earned less tax relief than he could have if he had waited so that he could get the increasing reliefs with age.
If the guy is 35 the age when he should stop contributing rises to 47.
If the guy is 40 then it is likely he can continue to claim max relief without hitting the threshold. I suppose this is the guy in your example as you talk of a 25 year mortgage.

If the guy expects his salary to rise it would be a further reason to delay pension contributions at least somewhat so as to enjoy the very generous 40% cap at 60 and over. If his fund by the time he reaches 60 is already "too big" he will miss out on these very generous reliefs.

*I have used 7% p.a. for the prospective calculation as if I used 5% p.a. I would be running a big risk of breaking the threshold.
** It is not just that the statutory threshold is €2m, beyond which there is double taxation, it is that at the margin the distributions on a fund this size would be taxed at 40%.
 
Duke, that's an interesting point, and analysis about attempting to maximizing lifetime tax relief on contributions.

Does it risk the tail wagging the dog?

Delaying contributions to pension to last possible moment to max contribution relief obviously has earnings, pension policy and health risks.

At the edge, putting all the pension in cash would also maximize opportunity for relief before 2M. But that sounds very suboptimal given our tax regime.

It also doesn't consider opportunity cost of having limited early retirement option.

Assuming you will have excess cash available, beyond paying down mortgage, It also doesn't compare putting it in pension vs investing outside of pension.
 
SPC100 said:
Duke, that's an interesting point, and analysis about attempting to maximizing lifetime tax relief on contributions.

Does it risk the tail wagging the dog?

Delaying contributions to pension to last possible moment to max contribution relief obviously has earnings, pension policy and health risks.

At the edge, putting all the pension in cash would also maximize opportunity for relief before 2M. But that sounds very suboptimal given our tax regime.

It also doesn't consider opportunity cost of having limited early retirement option.

Assuming you will have excess cash available, beyond paying down mortgage, It also doesn't compare putting it in pension vs investing outside of pension.
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All valid points. Still at those levels, "use it or miss it" is less convincing than at lower levels.
 
Duke of Marmalade said:
He would be advised to stop contributing immediately and in fact he has earned less tax relief than he could have if he had waited so that he could get the increasing reliefs with age.
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That is a very interesting point which I had not heard before. Can I check if I understand it correctly?

If a 30 year old maxes his contributions , then the growth of the pension fund will bring him up to €2m.

So he would be better off making lower contributions to reach the €2m mark by contributions rather than through investment return?

Brendan
 
It’s a circular argument, no?

Firstly, we’re talking about a time when someone has spare cash, which they probably didn’t in their 20s.

How exactly does €287,500 contributed over 10 years grow to €2.15m?

Surely the obvious point is to load up the pension earlier and get larger amounts working for longer.

Then, maybe, kill off the mortgage in one’s early 50s?

But, in a world where we have macroprudential mortgage rules anyway, we should ignore our mortgages and focus on retirement funding. The mortgage will take care of itself and is a payment for housing anyway.
 
Brendan Burgess said:
That is a very interesting point which I had not heard before. Can I check if I understand it correctly?

If a 30 year old maxes his contributions , then the growth of the pension fund will bring him up to €2m.

So he would be better off making lower contributions to reach the €2m mark by contributions rather than through investment return?

Brendan
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Roughly, yes. It is assuming a very high level of contribution, €28,500 and for 8 years. It is premised on it being bad news for a pension fund to exceed €2m standard threshold (reduced from €2.15m), which I think is hard to argue with.
As @SPC100 points out there are a lot of moving parts to the argument. One would need to equalise net investment by investing outside the pension fund to have a true apples for apples comparison, but yes funding your pension too early could deny you the very generous 40% cap at age 60 when your salary may be at its highest.
Gordon Gekko said:
How exactly does €287,500 contributed over 10 years grow to €2.15m?
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I assumed 7% p.a. which over 30 years would have that effect. If one used 5% p.a. you might be safe but you then run the asymmetrical risk that the fund will exceed €2m and that is, I think we agree, bad news. One could argue that if that showed signs of happening you could switch your fund into cash, but that does seem circular.
Gordon Gekko said:
Surely the obvious point is to load up the pension earlier and get larger amounts working for longer.
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For a truly apples for apples comparison one would need to invest outside the pension fund, perhaps by paying down mortgage, to compensate for delaying getting the tax relief.
 
I have done an apples for apples calculation.
30 year old earning €100k p.a.
salary increases at 3% p.a.
Growth net of charges 5% p.a.
(1) he maxes pension contribution from the beginning but stops when the fund projects at 7% p.a. to exceed €2m. This actually involves him stopping and starting pension contributions as the 5% growth undershoots the 7% safety margin, but this is a theoretical exercise.
(2) he goes to the other extreme and delays pension contributions until age 50.

In each case he finishes with a pension fund of c. €2m.
In (1) he gets nominal tax relief equal to €326k and in (2) he gets €547k.
To equalise cash flows we must invest/divest the difference between (1) and (2) in an ordinary equity fund, which means that in (2) one is investing the saved net pension fund contributions from (1) in a non pension fund so as to fund the extra net pension contributions later on.

The required return on non pension funds for equality is 4.3% p.a.
This is higher than the equivalent return of 3.1% (41% exit tax on 8 year gross roll up at 5%).
So after all (1) is better than (2), apologies @Gordon Gekko
But it is fairly marginal, so it is not quite as bad as "use it or miss it".
 
I’d have to see the calculations.

It sounds wrong; how does a non-company owner starting pension funding at age 50 get to €2m?

Tax relief of €547k in Scenario 2 implies total contributions of €1.4m over 15 years (assuming a retirement age of 65). That’s personal contributions of circa €91k a year which wouldn’t be allowed.

There’s a fundamental error somewhere in your numbers.
 
While it’s obviously not guaranteed, I would have a high degree of confidence that the return on a decent global equity fund held within a pension wrapper will exceed residential mortgage rates over a 30-year year holding period.

I wouldn’t have the same degree of confidence on the outcome over a materially shorter holding period.

That’s one of the key risks of deferring pension contributions in favour of paying down a mortgage ahead of schedule - the loss of “time diversification”.
 
Gordon Gekko said:
I’d have to see the calculations.

It sounds wrong; how does a non-company owner starting pension funding at age 50 get to €2m?

Tax relief of €547k in Scenario 2 implies total contributions of €1.4m over 15 years (assuming a retirement age of 65). That’s personal contributions of circa €91k a year which wouldn’t be allowed.

There’s a fundamental error somewhere in your numbers.
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I attach the spreadsheet.
By retirement age, his salary is €289k and his pension contribution is €116k. It's the eighth wonder of the world.
 

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