The 2019 ISA season is now in full swing, and it's as good a time as any to focus on financial planning - and, within that, looking ahead to your retirement years to ensure financial security.
Pension vs property
The housing crisis in the UK needs little introduction, and the statistics say it all. Rates of home ownership plummeted from 73.3 per cent in 2007 to just 63.4 per cent by the end of 2016. It represents the biggest plunge in home ownership of any EU country since the financial crisis.
No single issue has served to widen the inter-generational divide more than home ownership rates, with those under the age of 40 considerably worse off. According to the Institute for Fiscal Studies (IFS), 43 per cent of those who were born in the late 1970s owned their first home by the age of 27. For those born five years later, the equivalent figure is 33 per cent, while for those born in the late 80s, just a quarter could lay claim to home ownership before their 28th birthday.
The decline in youth home ownership rates is true of every major region in the UK, and the IFS lays the blame squarely at the door of soaring house prices, with the average house price having nearly trebled in the two decades between 1995/96 and 2015/16 - even when adjusting for inflation.
Getting a foot in the door
Interestingly, a study by Prudential found that one in six Brits between the ages of 18-34 believe home ownership is not a realistic lifetime goal for them, while 11 per cent said it is not even a priority at all. One could argue that those figures are rather high. However, given the scale of the housing crisis illustrated by the IFS data summarised above, perhaps the bigger surprise is that there isn't a higher level of disenchantment among youths.
In fact, the same Prudential study found that one in five 18-34 year olds are so hellbent on saving up to gain a foothold on the housing ladder that they are shunning increasing contributions to a pension scheme to facilitate this. Indeed, more than a third of respondents within this age bracket said that owning a home is a greater priority for them than saving towards a pension, while 21 per cent say they have not put a penny towards a pension to date - a finding that resonates with a 2017 study conducted by Lending Works.
Have millennials got their priorities right?
Aside from being ingrained into the fabric of our society, the allure of home ownership is obvious. Rents are extortionate in many parts of the UK at present, and in many cases exceed the equivalent costs of a monthly mortgage repayment. Paying off a mortgage also builds net asset value, unlike rent. And the prospect of being mortgage-free by the time an individual reaches retirement cuts out a significant living cost during one's later years, which in itself frees up pension cash to be used on other things.
Nevertheless, the idea that saving towards a pension and a home should be mutually exclusive sits uncomfortably with many pension experts. Retirement may appear to be a long way into the future for millennials, and thus slip down the totem pole of priorities as a result. Yet being caught short financially when reaching retirement age is a major concern for our society, with the aforementioned Lending Works research finding that some 34 per cent of UK adults believe they will never be in a position to down tools, while a similar FCA study found that one in three Brits plan to rely solely on the state pension.
The benefits of compound interest
This is where the power of pension saving comes in - and making an early start to boot. One of the most powerful tools in economics is also one of the most poorly understood: compound interest. Compounding refers to the addition of interest earned (or investment returns) to the principal amount, with interest then subsequently being calculated on this combined balance. This process then perpetually repeats itself, with the overall sum growing rapidly over time.
The most crucial principle underpinning the power of compound interest is, quite simply, that the earlier you start, the greater the level of exponential growth in the invested balance. This concept is directly applicable to pension saving too, and unfortunately those who forego the opportunity to start saving early fall further behind than they might think.
To take a rudimentary example: imagine person A starts putting £100 towards a pension each month from the age of 20 and earns an annual interest rate of 3 per cent (compounded monthly, no adjustment for inflation). If they continue to make this same monthly contribution, by the time they reach the age of 65, their pot will be a whopping £114,322.
Now imagine person B contributes the same monthly amount, at the same rate of interest, but only starts doing so at the age of 40. Their pot, by the age of 65, will be just £44,712 - or a difference of nearly £70,000 to person A, even though the difference in actual contributions between the two over the 45-year period is a mere £24,000.
Can we turn the tide on pension saving?
To some extent, we already are. The Government's auto-enrolment scheme, whereby employers are obliged to match employee contributions to a certain level (unless they opt out), essentially amounts to free money for workers, and uptake has been strong since the policy was rolled out in 2012.
The obligatory worker contribution rate was increased from 1 per cent to 3 per cent in April, with a further increase to 5 per cent in the pipeline for 2019. Fears were that such a jump would lead to a spike in opt-out rates, but various studies have found this not to be the case thus far.
That said, attitudes remain alarming, with Prudential’s research citing that 15 per cent of 18-34 year olds simply aren't motivated by pension saving, while 12 per cent went as far as to say pensions are 'irrelevant' to them.
Certainly, the goal of home ownership is an admirable one, and has its foundation set in sound economic sense. Yet the pursuit of such an objective at the expense of a pension, and all of its almighty power, is a grave error. Auto-enrolment is a policy to laud and should continue to raise the bar. But policy should be just the start: even more urgent is the need to educate and impress upon today's younger members of society the importance of being adequately prepared for their golden years - however far away they may seem.
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