A question we are asked when starting a new job is whether we want to ‘opt out’ of the company pension scheme and we are given very little context or follow up information to help us decide whether we should opt out. In our current environment with many of us struggling to make ends meet and having to cut out many monthly costs that are not an absolute necessity, we face the dilemma of do we ‘lose out’ on a portion of our well-earned salary to fund a distant future or do we take home all the money we possibly can at this time to keep things afloat at home. Thus, leading us to think, is a pension really worth it for me at this time?
Under current workplace pension rules, also known as ‘automatic enrolment’, you are automatically enrolled into a pension scheme (if eligible) and make minimum pension contributions based on your Qualifying Earnings (total employment earnings that fall between £6,240 and £50,270 before tax). Of these total pensionable earnings your employer is required to make a minimum contribution of 3% and you personally 5%, although on your personal contribution you receive tax relief from the Government at your rate of income tax rate. The case study below goes into more detail as to how this works in reality. Also note that, although your employer is required to make a 3% contribution, some generous employers may actually contribute more than 3% so this is a question worth asking your employer.
Case study A – workplace pension contributions
Mr Owens is age 25 and earns a salary of £30,000 per annum. This means his total pensionable earnings are £23,760 (£30,000 - £6,240), his employer pays the minimum 3% of salary into his pension and Mr Owens to pays 5%.
- Mr Owens’ annual contribution: £1,188 - £950.40 of which is from Mr Owens, £237.60 is the 20% tax relief applied to his personal contribution from the Government as he is a basic rate taxpayer.
- Mr Owens’s employers’ annual contribution: £712.80.
- Total pension contribution for the year: £1,900.80.
This example demonstrates that for a cost of £950.40 for Mr Owens personally, he actually receives £1,900.80 into his pension for that year. To break that down realistically, as most people’s pension contributions are taken monthly, Mr Owens would pay £79.20 personally per month and receive a total monthly contribution of £158.40, seemingly it’s a no-brainer to remain in the pension scheme.
With the retirement goal posts appearing to be moving further away for most of us, it is easy to fall into the trap of thinking “I’ll cross that bridge when I come to it” or “I’ll opt out for this year and join next year” but never actually get round to it, and this thinking can quickly lead to us missing out on ‘free money’ from your employer and potential valuable growth without realising it.
Compound growth is essentially ‘growth on growth’ in that, in our first year of pension contributions the money invested will grow, then going into our second year you should experience growth on not only the initial contributions but on the growth from the first year and the second years’ worth of contributions, and so on in the following years. If you use the principle of compound growth and the fact that growth within a pension is tax-free, it is clear to see that the sooner you begin contributing to a pension the better it is. It should also allow you to be under less stress and pressure when you reach retirement as you will know the contributions you made 40-50 years prior are still working hard for you hopefully reducing the need to make extremely large contributions 5-10 years before you retire.
Referring back to the previous case study of Mr Owens aged 25, we can demonstrate the benefits of him starting his pension savings now to retire at age 68 as opposed to beginning his pension planning at age 58, ten years before his desired retirement.
Case study B – compound growth
Mr Owens agrees to invest his pension contributions with a ‘medium’ level of risk, so we are going to reasonably assume his pension grows by 4% per annum after all charges. (It is important to note that this figure is just an assumption and the growth each year may be more or less than 4%).
If Mr Owens began with his pension contributions of £165.90 per month (figure from case study A) now at age 25, with 4% growth per annum and no assumed increases in salary each year, he could at age 68 have around £227,378 in his workplace pension.
In contrast if Mr Owens left it to age 58 without contributing to a pension and decides at this point to go ahead with the total £165.90 per month contributions, even with the 4% per annum growth, at 68 he would have around £24,429 in his workplace pension.
This demonstrates a difference of £202,494 that Mr Owens would have lost out on just by taking an extra £79.20 home each month of his working life and spending it, rather than investing it in his pension and benefitting from employer contributions, tax relief and tax-free investment growth.
The case studies demonstrate just one of the advantages of setting up a pension early when retirement is not the first thing on your mind. Pensions are extremely tax efficient, long term investment planning vehicles that should be taken advantage of as soon as possible for each individual.
In short, the answer to the question is that pensions definitely are ‘worth it’. Although the current mindset of cutting out unnecessary bills is completely understandable, it is important that you think of your pension contributions as a necessity rather than putting them under the same category as the three separate streaming services you pay for, or the gym membership you promised yourself that you would get around to using this month.
This article is written by one of our Trainee Consultants, Megan Leach.