The pension fallacy (Part 6)

By Slow Dad - April 01, 2017

For a financially independent person, pensions are optional. In fact they can even get in the way of achieving early retirement altogether.
This is the final post the recent series talking about pensions.

I am going to assert my cantankerous side and make what will likely be a controversial observation: for a person who is serious about a financially independent early retirement, pensions are optional.

"Serious about early retirement? Then pensions are optional"
In fact I would go so far as to say in the United Kingdom the use of a private pension will likely delay your achieving of Financial Independence.

Now before you have an aneurysm or the financial planning orthodoxy start burning me in effigy, let me outline my argument.

Pensions are great investment vehicles for the masses

I am a big believer that everyone should save a significant proportion of what they earn.

My preference is that, apart from a shock absorbing emergency fund to smooth out the ride, those savings should be invested in a globally diversified portfolio spanning multiple asset classes.

Investment decisions should always be based upon their own merits. Tax considerations should only ever be a secondary factor.

In other words first you should pick an investment that meets your selection criteria. Once you have found a good investment by all means figure out the most tax advantageous means of acquiring and holding that investment.

The taxation issue is worth some elaboration.

The United Kingdom’s government finances are in a perilous state. As the chart below highlights, were the number one rule for personal finance success, "spend less than you earn", to be objectively applied to the government’s books then they would be found wanting.
Budget deficit as percentage of GDP

Regulatory risks and moving goal posts

Over the past several years one of the few consistent messages from successive governments has been the way the tax authorities are increasingly coming to view tax avoidance (the technically legal “following the letter, if not the spirit of the law” one) and tax evasion (the illegal one) as being shades of the same thing. Monevator recently wrote an article that covered this pretty well.

Many of the opportunities for personal finance taxation arbitrage have been (or are in the process of being) closed off. There are many examples of this emerging pattern.

The removal of buy-to-let mortgage interest relief for non-corporate buyers.

The watering down of double taxation provisions, via the elimination of dividend tax credits.

The recent attempted conformance of taxation rates for self-employed workers.

The rapidly increasing number of organisations making blanket IR35 status determinations for all their freelance subcontractors.

The penalties being imposed on pension transfers when you live in a different locale to where your pension is located… a swift kick in the nuts for those British expats who settled in sunnier climes post retirement.

The list goes on.

While the government is cracking down on everything else, for now the government appears to be encouraging the use of tax free ISAs (containing after-tax funds) and self invested private pensions (containing tax deferred funds, that cannot be applied to direct property investments).

However even these are being reigned in, with lifetime contribution limits and differential taxation being imposed depending on your income.

Which brings us back to pensions

Pensions are one of the few remaining significantly tax advantaged options open to individual workers, particularly to freelance contractors.

Which is great, providing those workers are willing to delay being able to access those funds, or any income they generate, until the pension eligibility age.

That is a small problem if the worker is near that age, but a much larger problem if the worker is at the early end of the “early retirement” spectrum, for example in their 30s or 40s.

If they had been lured by the siren song of tax deferred pension accounts, then they will fall into the classic “asset rich, but cash poor” category.

To me that is a disappointing state of affairs, akin to a little kid being let loose in the Lego store to marvel at all the cool stuff, only to be told they can’t take any of it home with them.

Though, as with the Lego store, any toddler tantrums that ensue are more down to poor planning and a lack of understood about what should be clearly defined boundaries.

Perpetual money making machine

My contention is that if you need to establish a means to provide for yourself in early retirement, then there should be no reason why those same means can’t support you in perpetuity.

Once you venture down that particular avenue, it calls into question whether you actually require a pension at all.

You should already have constructed a sustainably renewable passive income generating machine.

Unless of course you worship at the idol of 4% rule "safe withdrawal rates", with a financial plan that resembles a game of chicken... betting that your life runs out before your wealth does!

Does your financial plan that resemble a game of chicken, betting that your life runs out before your wealth does?

So what?

I would argue that as an enforced means of savings pensions are an effective, if restrictive, tool. However what is applicable to the consumption charged masses does not necessarily translate quite so well when applied to a prospective early retiree.

I use the term early retiree literally. I’m not talking about all those people with a pipe dream and FIRE orientated blog. Rather I mean people who have actually got their shit together well enough to not only know exactly how they will sustainably replace their earned incomes, but who can also plot out with a reasonable degree of certainty exactly when they will be able to do so.

If you can do that then the adoption of pensions becomes a cost benefit equation, the utility of being able to access the funds today (and invest them in things like residential property) versus the prospect of potentially lower marginal tax rates at some (potentially distant) point in the future.

Optimal cost benefit, it is all about balance.

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  1. Love the metaphor of a kid in the Lego store! I do believe that the pension fund is still a great tool for everyone as they are protected against bankruptcy and are not considered as part of the assets assessed for benefits (I say that with a pinch of salt though). Likewise, it can be used to allow higher tax credits since the gross contribution into pensions are partly or fully discounted in the context of the income.

    Still, thank you for doing a great series of useful posts on them! :)

  2. Thanks for writing these series sir. I've been reading since start and although they haven't received too many comments, it is a solid argument with ways of application. Great food for thought, much appreciated

  3. Good points JoeCrystal.

    I'm no expert, but my understanding of the bankruptcy rules are that pension assets may be protected... unless the Trustee In Bankruptcy considers that the person declaring bankruptcy had made "excessive" contributions which are defined as being "unusually high" contribution levels.

    Given that the vast majority of folks never make more than the bare minimum levels of contribution, pretty much any amounts over the minimum could be considered unusually high! This becomes a somewhat subject evaluation for the courts to determine whether the contributions were made out of a desire for a secure financial future, or were made to deprive creditors of funds owed.

    The tax credits element of UK pension contributions are certainly one of the most attractive elements, particularly for business owners and freelancers. If a person doesn't need to access the funds until they reach pension eligibility age then this is certainly an attractive tax arbitrage opportunity. That is a big caveat for many people working towards an early retirement date however, which should be reflected in their planning.