your pension should be worth more than your house by the time you retire

Interesting point made by Jonathan challenging my assertion that for the middle class, buying their house is nearly always their biggest cost. Jonathan took a total lifecycle point of view

Well, no. For the middle class, our biggest cost is now building the defined-contribution pension fund.

Although I was thinking of the monthly running cost in saying the house was the largest cost he made me think, and run the arithmetic. In my area a family home is about 5-6x  the middle household disposable income of 24,400, according to the ONS[ref]Middle income Households 1977-2011 Note this includes Londoners, so in my area the median income is probably significantly lower[/ref]. I was seriously gobsmacked by that disposable income – here’s the infographic, I didn’t dream it up.

 incomes of households in the middle of the income distribution (ONS)
incomes of households in the middle of the income distribution (ONS)

I looked for a second source[ref]f’rinstance check this Grauniad article on the subject – a couple with two kids would be in the middle with a post-tax income of 31k, I wouldn’t find 31k that out of keeping with the ONS 24k disposable income (ie after rent) [/ref] but it seems to stack up. I had a much lower estimate for disposable income, from all the hollering you get in the papers about the squeezed middle. I’m still finding this hard to believe. Looks to me the squeezed middle is sitting pretty and it supports my feeling that Britain is far, far richer than the Britain I grew up in (I left home in 1978, a year after the infographic’s start date). We should bear in mind that the middle is defined in the logical American way, rather than the British way, where nearly everybody seems to define themselves as the middle class unless they are members of the landed aristocracy or they’re currently wiping down their hands on their blue overalls at the time they are polled.

Much of the screaming from the squeezed middle you hear about in the papers would be from what the Americans would call the working class if they were to use such a term. The ONS defines the middle in a different way to most British journalism, though logic is on their side.

This middle exists, in a Britain where I saw a van today that would come and valet your car onsite, FFS. Another van drives around supplying ironing service to suburban households, while another trails the city dustcarts and pressure washes your wheelie bins for you for a fee. All these goods and services are presumably some of what that 24k median household income goes on, while the rest of us seem to be ramping up our credit cards again. The ‘squeezed middle’ feels squeezed because before 2007 it spent a lot of its disposable income and consumer credit  on consumer goods, a hell of a lot more than it did 30 years ago. Although the 1970s had issues, I don’t think that people were anywhere near as miserable[ref]Britain’s happiness in decline – BBC – from 2006, I shudder to think what it looks like now![/ref] as you’d expect only spending half as much on consumer goods, and consumer goods now are probably far better value in general now 😉

People will cite housing as the major source of hurt nowadays  but the average house is about 5-6x household annual income. I paid 5x my annual income when I first bought a house. I recall sitting in the Broadcasting House bar in 1988 grouching into my beer about how it wasn’t fair I could never buy a house etc etc, just like Generation Rent do now – and eventually identified my problem and got the hell out of London. Generation Renters might want to observe that buying a house soon after that on such a high income multiple still classifies as the most stupendous personal finance mistake I have ever made, although some social trends [ref]I started work before the arrival of women into the workforce that started in the 1970s was complete, so I was competing with a mix of single earner households and two-earner households[/ref] may mean income multiples need to be considered for a couple rather than an individual; I was single when I bought that house so there was only one earner by definition. I also needed a 20% deposit. Look also at the 5% fall in direct and indirect taxation between then and now.

However, Jonathan is absolutely right, if this median couple had accumulated a pension fund of 150k this would pay about 5% annually, roughly £7500, which is a big climbdown on their 24k previous disposable income[ref]The State Pension would be about £7500 for each of them, so this isn’t necessarily a terrible position, it depends how old they want to be when they retire – added in that brings them up to over half their pre-retirement disposable income[/ref]. If they doubled their savings, the savings would pay about half their pre-retirement disposable income ,which was the usual target for a final salary pension scheme.

However, even if they target pension savings of twice the house price in real terms, the house will still be their largest cost in the 30-50 year old range while they are servicing the mortgage. This is because unlike a pension you want to use a house before you’ve paid for it so you have to pay interest, that usually ends up being about twice the original price in real terms when you tot all the repayments up, and allow for the fact that your later payments are made in money that’s worth less due to inflation (you typically pay about three times the nominal purchase price over 25 years).

Added to that you buy your house over about 25 years, whereas if you start early you have 40 years to buy a pension. [ref]this is slightly misleading as in practice you may do much more of the heavy lifting in the later years, when you may be a 40% taxpayer, you probably earn more and you may have paid off your mortgage, meaning you can save more out of pre-tax income. The magic of compound interest roughly doubles the value of your early payments over 40 years – my savings profile much more than doubled as I got older, so my later contributions are more significant than my early ones.[/ref]

You need a lot of money to end up like this in retirement rather than rooting about in the bins like Top Cat, so go easy on buying too much house if your pesnion fund ends up less than the price of your house... (photo LdF/iStockPhoto)
You need a lot of money to end up like this in retirement rather than rooting about in the bins like Top Cat, so go easy on buying too much house if your pension fund ends up less than the price of your house… (photo LdF/iStock)

It’s a sobering thought, however, that you should have a pension savings target of twice the value of your (paid off!) house. Consumerism does enough of our heads in that some people appear to be surprised to find out that an interest-only mortgage doesn’t actually buy you the house and act all surprised at 50 that you can’t have lots of foreign holidays, school fees and what-have you and get to own your house.

Because of the peculiar emotional magnetism of housing to Britons’ national characters many people end up with far too much house relative to their pension savings. It isn’t easy to sell your house off brick by brick, and there seem to be issues with equity release schemes, but that’s where you’re going to end up if you have loads of house equity but sod all pension income/free cash flow. So beware, all those who say my house is my pension. Who are you going to sell it to, and how? In my experience of ex-colleagues surprisingly few people really do downsize when the kids fly the nest (assuming that they do, of course). They get used to a house and it seems to encapsulate all sorts of warm fuzzy happy memories. It just doesn’t seem to happen that often, even in cases where it would help financially strapped empty nesters. The child-free have an easier time in this regard as their housing requirements don’t have to increase to accommodate kids and then contract again afterwards.

I came across this backwards – I looked at what I wanted to achieve as my desired early retirement pension income. I discovered I ended up with big numbers. I had to target ISA and AVC savings so unlike many Britons the sunk cost of my house is quite a bit less than half of my net worth[ref]I also don’t count the house as part of my net worth, more as part of my income in the rent I don’t have to pay[/ref]. However, it’s notable that most of my ex-colleagues had much better and more expensive houses – their relative asset allocation was usually much more housing-heavy than mine. I get the feeling that for most Britons their house is their largest asset by the time they retire.

This fondness and faith in property leads Britons to go into BTL and indeed purchase property abroad. Although buy-to-let is a business, it does also increase exposure to residential property as an asset class. I don’t know enough about BTL to know if BTL mortgages come with recourse, ie the mortgage company can come chasing you for other assets other than the house the loan is secured on. If it did I could see a world of hurt under some circumstances (rising interest rates being the most likely).

However, if these middle class households really do have 24k disposable income per annum, then they have no excuse for failing to save or a pension. Let’s face it, stick half that into index-linked savings certificates that track inflation but don’t pay a real return, and 20 years later you have more pension savings than the average UK house price.

It’s not as horrendously big an ask as it first sounds, because you actually save for a pension before you use it, unlike that house. In practice it will cost about the same or perhaps less in total lifecycle cost, because you don’t pay interest on it, and you benefit from up to 40 years compound investment return on the savings. You also don’t get any tax breaks on buying the house.

But you do have to start, and like for any large savings goal the earlier the better…