Workers are expected to shrug off a big rise in pension deductions starting tomorrow, as a combination of inertia and self-interest keeps most people saving into retirement pots.
Millions of people auto-enrolled into pensions will see minimum payments jump from 2.4 per cent to four per cent of their wages at next payday.
Lack of knowledge or interest about pensions, plus pay rises and advantageous tax changes, are likely to keep the opt out rate at around nine per cent.
Auto enrolment: Millions of people will see minimum pension payments jump from 2.4 per cent to four per cent of their wages
Workers who do swallow the increase stand to benefit greatly due to free top-ups from employers and the Government, plus the compound effect of investing over long periods.
However, more low earners are going to be affected by a technical quirk which prevents some from getting the Government cash paid to the better off, purely due to the ‘lottery’ of what type of pension scheme their employer has chosen. See the box below.
Auto enrolment is a huge and so far successful initiative to get people saving for old age by signing everyone up unless they actively choose to opt out.
There was little sign of workers ditching pensions after an increase in minimum contributions at this time last year.
Why are some low earners losing pension top-ups?
Half a million more low paid workers will be deprived of free pension top-ups from the Government from April 6.
That’s on top of the 1.22million people already estimated to be missing out on up to £720 of government pension cash a year.
This is because the Government has frozen the earnings threshold at which people are automatically enrolled into pensions at £10,000. Meanwhile, the personal allowance, the level at which people start to pay tax, is set to rise from £11,850 to £12,500.
Some people who earn between those two sums lose pension tax top-ups – but whether or not you miss out depends on the tax mechanism used by your work pension scheme.
Most master trusts, which manage centralised funds for lots of employers at once, use a system called ‘net pay’ that is convenient for top-paid staff but penalises lower earners. Read more here.
Pension payment rates are levied on the portion of people’s wages that falls under the auto enrolment rules – between £6,136 and £50,000 from 6 April.
Free top-ups from employers plus Government tax relief (for all except some low earners) mean that the total amount of workers’ ‘band earnings’ put aside for retirement will rise from five per cent to a total eight per cent.
This year’s rise will see deductions jump from £50 to £83 a month for a worker on £25,000 a year.
But figures compiled by investment manager 7IM for This is Money show a 25-year-old worker on £25,000 could be sitting on £403,000 by the time they are 65 if they contribute at the new rate, compared with a pot worth £252,000 at the old rate.
7IM used a relatively optimistic six per cent rate of investment return, but this is not unachieveable given it is calculating potential rewards on a 40-year time horizon.
The impact of pending rises on workers earning £20,000, £30,000 and £50,000 a year was calculated by AJ Bell, and is shown below.
‘While for some – particularly those struggling to make ends meet – this increase might lead to a re-evaluation of whether to continue saving for retirement through the workplace, experience to-date suggests for the majority inertia remains a powerful force,’ says Tom Selby, senior analyst at AJ Bell.
‘Furthermore, rising average wages mean lots of workers will at least not see a dramatic drop in their pay packet, although real wages could well dip.
‘Anyone who chooses to opt out is basically taking a voluntary pay cut. Employers will have adjusted remuneration packages to take auto-enrolment into account, so if you turn down the matched contribution you won’t get it back elsewhere.’
Auto enrolment minimum payments: The impact of pending rises in contributions on workers earning £20,000, £30,000 and £50,000 a year (Source: AJ Bell)
Nathan Long, senior analyst at Hargreaves Lansdown, says: ‘Auto-enrolment has revolutionised retirement saving in the UK, with our pay packets absorbing all that’s been thrown at them so far.
‘April’s contribution hike is yet another hurdle to clear before we can be confident we’re in better retirement health.’
But he adds: ‘Only relying on inertia to provide for us in retirement is dangerous. Auto-enrolment is a little like a cheap balloon at a kid’s party.
Give dukes and dustmen the same pension boost
Ex-shadow minister Gregg McClymont warns the Government to play fair on top-ups here.
‘The more you inflate, the better it gets, but at some point it cannot take any more.
‘The focus now needs to switch to getting people to understand how paying in more personally or improving their investment returns may boost their income or allow early retirement, rather than forcing them to pay more in automatically.’
Gregg McClymont, former shadow pensions minister and now policy director at The People’s Pension, criticised the Government’s failure to fix the tax technicality that means more low paid people will miss out on pension tax relief that the better off have added to their pots automatically.
‘Millions of lower-earners – the vast majority women – are being deprived of a much-needed boost to their pension pot due to a tax flaw.’ he says.
‘Those who need to increase their retirement savings most are being let down by an avoidable issue which threatens to damage public confidence in the system.
‘It was disappointing that the government missed the opportunity to address this issue in the Spring Statement. As thousands more people will be affected following April’s income tax threshold increase, fairness demands it be fixed urgently.
‘The Government must find a solution that allows all savers to receive the tax relief they’re entitled to.’
How the changes could mean a £151k pension boost for a 25-year-old – and the cost of delay
Source: Seven Investment Management
The 7IM figures above show the significant hikes to minimum pension contributions, and what size of pension pot you could end up with assuming six per cent investment growth over 40 years.
A 25-year-old worker on £25,000 could end up with a pot worth £252,000 at the current contribution rate.
However, by stumping up the new higher contributions they could be sitting on £403,000 by the time they are 65.
The figures also reveal the massive disadvantages of delaying saving into a pension until you are older.
It is still worth starting into a pension at a later stage, but you will end up with a much smaller pot than you might have done.
7IM also explains how to beat the challenge of saving for a pension and a deposit for a house at the same time.
The firm says it is possible for a 25-year-old couple to buy a house worth £220,000 in five years’ time, and still end up with combined pensions worth £806,000 at age 65. Find out how here.
TOP SIPPS FOR DIY PENSION INVESTORS