3 powerful reasons you shouldn’t reduce your pension contributions during the cost of living crisis
Posted onThe cost of living crisis hasn’t been far from the news headlines for a few months now.
Soaring energy costs and a rise in the energy price cap have contributed to the highest inflation rate in 40 years, with the Office for National Statistics confirming the headline rate hit 9% in the year to April 2022.
Add to that rising food prices, an increase in the rate of National Insurance contributions (NICs) and Dividend Tax, and rising interest rates that may have pushed up the cost of your mortgage, and it’s easy to see why millions of households are seeing expenses rise sharply this year.
If you – or perhaps a child or grandchild – are having to make savings, one thought might be to reduce your pension contributions for a spell. However, doing this could damage your long-term security. Here are three reasons why.
1. You could lose matched employer contributions
If you’re in a workplace pension scheme, it’s highly likely that your employer makes contributions to your pension on your behalf. Indeed, by law, employers must pay 3% of your earnings in most cases.
If you decide to reduce or pause your own contributions, you could forfeit your employer contributions. You’ll be at risk of losing that 3% employer contribution altogether – essentially reducing your earnings by 3%.
Aegon analysis published by Pensions Age showed a one-year pension contribution break could mean a 25-year-old on average earnings, and contributing the minimum auto-enrolment level, could miss out on £4,600 at State Pension Age.
And, as well as losing out on their own contributions, Aegon warned that a one-year break would mean missing out on £683 of contributions from their employer, warning that “forfeiting these valuable contributions effectively means you lose out on ‘free’ money from the employer”.
2. You’ll lose valuable tax relief
When you save into a pension, whether through a workplace scheme or into your own pension, the government boosts your pension contributions through tax relief. This is true if you’re employed or self-employed.
What it means is that money you would have paid in tax on your earnings goes towards your retirement savings instead.
The amount of tax relief depends on the rate of Income Tax you pay.
If you are a basic-rate taxpayer and were to contribute £100 from your salary into your pension, it would actually only “cost” you £80. The government adds an extra £20 on top – equivalent to what it would have taken in tax from £100 of your salary.
If you’re a higher- or additional-rate taxpayer, a £100 contribution only “costs” you £60 or £55, respectively. Note that you need to claim this additional tax relief through your self-assessment tax return.
If you pause or reduce your pension contributions, you’ll also lose this valuable tax relief. As with employer contributions, it is essentially “free money” that is going in your pot to fund your retirement. If you cut or pause your contributions, you’ll lose this valuable relief.
3. You’ll miss out on compound growth
Compound growth is essentially “growth on growth”.
Think of it this way. If you invest £100 and get a 5% annual return, in a year you’ll have £105. If you get a 5% return in year two, you’ll then have £110.25. In year three, you’ll have £115.76.
So, while pausing or reducing your pension contributions now could save you some money, you’ll lose the potential returns from the money you’re no longer investing.
Add this to the potential tax relief and employer contributions you could lose, and it could add up to a significant sum by the time you come to retire.
HL provide a useful example.
If you pay £100 into a personal pension today, and you’re a basic-rate taxpayer, it’ll be worth £125 after tax relief is added.
Assuming it grows by 5% above inflation after charges, it could be worth about £540 in 30 years. If it’s a workplace pension where the employer has chosen to match the contribution amount, it could be worth £1,080.
Putting off your pension payments of £100 each month for a year could mean you miss out on between £6,340 and £12,680 in your pension after 30 years, assuming 5% growth after charges. That could mean you’d have to work a few more years to make up the difference.
Of course, you should remember this is using assumptions and isn’t guaranteed – tax rules can change, and benefits depend on personal circumstances. The contribution from your employer may also differ.
Get in touch
If you’re thinking about making changes to your pension contributions, or you’d like to find out if you’re on track for the retirement of your dreams, we can help.
Email us at enquiries@blackswanfp.co.uk or contact your adviser on 020 3828 8100.
Please note
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.
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