Pension Contribution Hikes Spell Good News Long-Term

The mandatory minimum contribution into workplace pensions has increased in April, as part of the government’s bid to prevent a future pensions crisis. Consequently, millions of workers who are paying the current minimum will see their take-home pay reduced – in exchange for ‘more jam tomorrow’.

From 1 April anyone enrolled into a workplace pension scheme must pay at least 5% of their salary into their pension pot, up from the current minimum of 3%. The increase is being introduced by the government to ensure that today’s workforce builds up sufficient savings to provide them with an income in retirement, and prevent them from becoming too much of a burden on the state in future years. However, for some workers (particularly those on lower salaries), this move may not be immediately welcomed, as it will reduce take-home pay in certain cases.

Around 73% of employees in the UK are enrolled in a workplace pension scheme, up from less than 47% in 2012, thanks to the government’s auto-enrolment scheme introduced in October of that year. Since then over 10 million workers have been enrolled into workplace pension schemes automatically, paying a portion of their salary into their pension pot each month. However, many who auto-enrolled did so on the minimum contribution level of 3% of salary, so will now see this rise and their take-home pay fall.

A short-term hit for a long-term gain

The move has drawn criticism from some quarters, with claims that workers will be hard-hit by even a small reduction their pay packets at a time of economic uncertainty.

Concerns around affordability have come to light with many touting that pay packets will be hit hard, which would be a blow to those concerned about current economic uncertainty. It has been suggested that the change may be counter-productive, by driving more people to opt out of their workplace pension scheme (an option under the rules) and putting them off saving into a workplace pension all together.

However, it is important to get the change in perspective. Analysis indicates that a person earning £30,000 who is currently making the minimum contribution will take home £253 less per year – or £21 less per month. For workers whose income and outgoings are very finely balanced, this might make saving harder and risk a build-up of debt, but the government is hoping that most will be able to absorb such a small reduction in light of the widely publicised benefits. Work and Pensions Secretary Amber Rudd, commenting on last year’s contribution hikes, said, ‘Some people were nervous we would see saving drop off. It hardly happened at all.’

The potential for a larger retirement fund

The point that the government is anxious to drive home is that workers are not losing this money – rather, they are saving it and increasing it through tax relief and compound interest. Basic-rate taxpayers (i.e. most workers) receive tax relief at 20% on every pension contribution, so every pound that is paid in becomes £1.25 in the pension pot (so is effectively a 25% increase). Growth on a pension pot is also tax-free.

This means that an individual earning £30,000 who goes from paying 3% to 5% could build a pension pot that is roughly £57,000 bigger than someone still paying 3% (based on 4% growth over 35 years). Yet, by paying in only £21 extra per month, this person would have paid in just £8,820 more over that time period. In short, the individual would be better off by some £48,000 thanks to tax relief and compound interest.

Financial advisers typically recommend that people save approximately 10 times their average working-life salary by the time they retire. So if that average is £30,000, people should be aiming for a pot of £300,000. That is a significant amount to save, so starting early is essential – and it may also require contributions that are above the new minimum of 5%.

The other bit of good news is that minimum employer contributions are also increasing from 2% to 3% in April (which the above calculations do not take into account). This will essentially boosting earnings by 1%, though this amount will go directly to pension savings.

If you would like to talk about any of the issues in this article or need more general help with your finances, please get in touch with us.

This article first appeared on Unbiased.