An important warning to every employee in the UK
Update May 2021: This blog has been updated. For the latest version go to "An important warning to every employee in the UK" blog, rather than reading this one.
This is a warning for every worker in the UK. Have you turned down a pay rise without realising it? Millions have done or risk doing just that. It happens when your employer ‘auto-enrols’ you into a pension scheme but you decide to opt out – in most cases a huge mistake.
Auto-enrolment is a rule which says companies must opt in their employees to pay towards a private pension – a savings scheme to provide money for you in later life, on top of the state pension.
However, crucially the firm must also contribute to your pension savings – on top of your salary. If you opt out of the pension scheme you don’t get this extra cash. The effect of this is a bit of a mind twist…
- EVERYONE WHO IS OPTED IN EFFECTIVELY GETS A PAY RISE… as your employer is giving you extra money you wouldn’t have got otherwise, even though it’s not immediately usable.
- EVERYONE WHO IS OPTED IN GETS LESS TAKE-HOME PAY… to get the extra money, you must save now; so your disposable income, the amount you can spend each month, is reduced.
If you’re struggling that’s likely hard to hear. Yet not doing it means giving up extra cash, and in turn that means running the risk of a cold baked bean retirement; as whether in future the state pension alone will be enough to live off is questionable. This is about saving now, so your living standards don’t plummet later.
Just to reiterate, DO NOTHING, and legally the default setting is some of your earnings are put towards pension saving. I’m in favour of this. Many people are scared of making financial decisions, and inevitably most of us are guilty of focusing on the now, not the future. This way, make no decision, and it’s hopefully the right one.
It costs just £40 to get £100 added to pension savings
If like most people you earn over £11,000 (and under £43,000), you pay basic 20% rate tax on all income above that, meaning for every £50 you earn you only take home £34 due to tax AND national insurance.
But pension savings come from PRE-TAX salary, so putting £50 a month in your pension only reduces your pay packet by £40 (£30 for higher 40% rate taxpayers). Plus, as often employers will match the £50 you put in, to get a total of £100 a month added to your pension, it only costs you £40 (or less with salary sacrifice, see below).
Over a year at this level of saving you’d pay £480 but your pension would have £1,200 added to it. That’s unbeatable.
From 2018 all employers must auto-enrol staff
All firms with over 50 people must currently auto-enrol all staff aged over 22 who earn more than £10,000 a year, and gradually smaller firms must too, until by February 2018 all employers will.
The minimum contribution usually taken from your salary is 0.8% (so £8 per £1,000 earned), and if you do that, firms have to add at least 1%, and over the next few years that amount will rise. Many firms will match your contributions above the minimum level, some adding up to 5% of your salary. It’s worth checking, and trying to take advantage.
How much should you save towards your pension?
Be prepared to have the pants scared off you. There’s a very rough rule of thumb that shows how much you should put in your pension for a comfortable retirement – roughly half to two-thirds of your final salary.
1. Take the age you started your pension and halve it.
2. This is the percentage of your salary that needs saving each year until you retire (thankfully it includes your employer’s contribution too). So someone starting aged 20 would need 10%, aged 30 would need 15%.
For most people these amounts are impossible, so don’t get too hung up on it. Instead just use it to realise that a) the sooner you start the better b) put in as much as you can afford.
One trick to boost your pension contribution, if you’re lucky enough to ever get a pay rise – immediately put a quarter of the new money towards your pension. That way, because you’re not used to earning it, you won’t miss it as much (I call this the forgotten gold technique!).
Aren’t private pensions a waste of cash?
You often hear people, especially those currently near retirement age, swear about how their pension has massively underperformed. Well that’s simply not true. No private pension has ever underperformed.
The confusion stems from a fundamental misunderstanding of what a private pension is. It’s not a product. It can’t underperform. It’s just a special wrapper everyone is given by the Government with the huge advantage that you save from pre-tax salary.
The problem is that historically most people invested their pension savings in ‘with-profits’ funds and these were often crap and many substantially underperformed. Yet don’t blame the pension wrapper for what was put inside it.
These days the choice of investment is much better, with lower charges and more transparency. Your firm’s pension provider should give guidance on what your options are.
Much of the choice is about ‘investment risk’. That sounds scary, but higher risk means you’re aiming for fast growth, but accept the fact there’s a bigger chance it may shrink. The younger you are the more room you have to take some risk, as if it goes wrong, there’s more time for things to even out.
Pension money can now be taken at 55, but it’s better to leave it until you need it. You’re usually allowed to take 25% of your pension as a tax-free lump sum. And with the rest you can simply withdraw it as cash if you want, but you must pay income tax on that.
The danger is, if you take too much out in one year, it pushes you up a tax bracket, which means you pay more than needed, so it’s important to plan how you get the money out. Full help in my free taking your pension booklet.
There’s nothing wrong with buying property, though of course you pay for it from your AFTER tax-salary; your employer won’t contribute. Plus even if house prices rise, at retirement it’s not easy to spend the house you live in, unless you sell or downsize, so it’s only a paper gain. Though a mortgage-free property does reduce your outgoings.
So both have advantages – if you’re fortunate enough to be able to do both, that of course is a boon.
You may be able to get even more via pension salary sacrifice
This is where you give up monthly earnings, say £1,000, and ask for your employer to contribute it to your pension instead. This gains you and your employer reduced national insurance contributions, which means you get more in your pension. So if we look at the example above, instead of it costing £40, it could actually only cost you £34 to put £100 into your pension (including the employer’s contribution).
In some cases generous employers will add the gains it’s made from national insurance into your pension too, adding even more.
However, it is worth remembering that technically this means your ‘salary’ has been reduced a touch, which while usually not an issue, could also affect eligibility for mortgage applications, state pensions and benefits, such as jobseeker’s allowance and employment and support allowance.
Is there anyone who should be opting out?
If you really can’t afford to contribute to your pension, you’ve a right to opt out. Think carefully before you do – generally you’re sacrificing long-term cash for short-term gain. However, there are some circumstances where opting out, or reducing contributions, does make sense, including…
- If you’ve very expensive debts, eg, payday loans or bank charges for busting your overdraft limit. Here it’s likely worth clearing these before you start to contribute to your pension.
- If you’re near retirement and have little savings. There is a chance that having a bigger pension pot could reduce your benefits, but this is quite a rare scenario.
- If you already have a pension, especially if it’s a very large one, then there is a risk auto-enrolment will put you over the lifetime allowance, which is currently £1 million. If you already have this or other complex pension arrangements, it’s worth speaking to your independent financial adviser. If you don’t have one, speak to Pension Wise.
Update: Isn’t there a risk the employer will take my cash?
I was surprised when I first published it at some of the comments, akin to “I won’t contribute because what happens if the firm loses money, like happened with BHS, then reduces the pension payout?”
I hadn’t included that in the article as that isn’t auto enrolment; it’s a totally different type of pension scheme (a final salary scheme). So rest assured, with auto-enrolment, you save a pot of money, your employer adds to that pot and that cash is held for you by an investment firm – the company has nothing to do with the money.
So the amount you’ll have in your pension pot when you retire simply depends on: 1) how much you have contributed to it and 2) how well the investment performs (after charges); rather than anything to do with the fortunes of the company you work for.
I hope you find this useful – it first appeared in my Sunday Mirror column. I’d love to know your thoughts below and also the deal your employer offers you (and did they also offer it before auto-enrolment?).