Opting out of automatic enrolment into a workplace pension for the first 10 years of working life could cut 20 per cent off the value of the retirement fund – nearly Ã‚Â£19,000 – for a median-earning man, according to research for Prudential conducted by the Pensions Policy Institute (PPI).
However, day to day financial pressures can make saving for retirement difficult for young people, particularly while they invest in building their career and starting a family. A careful balance therefore needs to be struck between the affordability of pension payments early in life, and understanding the financial impact that opting out will have later in life.
Effect of opt-out on median earning man
A man on median earnings of Ã‚Â£22,400 from age 22 to State Pension Age could expect a final pension fund of Ã‚Â£93,600 based on minimum contributions of 8 per cent of band earnings. This fund could generate a Ã‚Â£23,400 tax-free lump sum and a pension income of Ã‚Â£3,850 a year after tax.
If he opted out for the first 10 years, he may be Ã‚Â£620 better off annually in terms of disposable income by not making pension contributions. However, the impact of this later in life when taking into account the lost tax relief and employer contributions over that period, plus the long term investment return, could reduce his retirement fund by nearly Ã‚Â£19,000 to Ã‚Â£74,800. The tax-free lump sum could reduce to Ã‚Â£18,700 and the pension income could fall to Ã‚Â£3,100 a year after tax – an overall reduction of 20 per cent.
Barry O’Dwyer, Prudential UK deputy chief executive, said: “Auto-enrolment is expected to encourage an extra four to nine million people either to start saving into a pension earlier, or to save higher amounts. But we need to be realistic and recognise that for some young people starting out in their career or building a family, taking on the additional expense of investing in a pension may not be a high financial priority initially.
“That’s one reason why employer contributions and tax-relief on pension contributions are such important incentives – they don’t cost the individual anything yet they contribute significantly to the final value of a pension at retirement.”
Effect on lower earning woman
The cost of opting out could be even higher for a lower-earning woman on a salary of Ã‚Â£17,300 with a typical work history including a five-year break to care for children, two years to care for elderly parents and four years of part-time work. If she also opted out for 10 years at the start of her working life, she may be Ã‚Â£290 better off annually in terms of disposable income by not making pension contributions. However, the impact of this later in life when taking into account the lost tax relief and employer contributions over that period, plus the long term investment return, could reduce her potential retirement fund of Ã‚Â£35,000 by 25 per cent to Ã‚Â£26,100, providing a tax-free lump sum of Ã‚Â£6,500 and a pension income of Ã‚Â£1,000 a year.
Impact of more generous employer contributions
Unsurprisingly, the more generous the employer contributions, the bigger the pension fund that workers can accumulate. Prudential’s research shows that someone on median earnings in a more generous employer’s defined contribution pension scheme – for example with the current average of 2.5 per cent employee and 6 per cent employer contributions, plus 0.6% tax relief – could accumulate a fund of Ã‚Â£118,500. This could generate a Ã‚Â£26,600 tax-free lump sum and an income of Ã‚Â£4,900 a year after tax.
However, someone in the above scenario who opted out for the first 10 years could lose nearly Ã‚Â£23,000 from the value of their retirement fund, reducing it to Ã‚Â£95,800 with a lower tax-free lump sum of Ã‚Â£23,400 and a reduced income of Ã‚Â£3,950 a year after tax – an overall reduction of 19 per cent. Three quarters of the reduction in fund value would come from lost employer contributions, tax relief, and investment returns over the 10 year gap, the remainder coming from lost employee contributions. He would only pay Ã‚Â£530 less in pension contributions each year over the 10 year period in which he was opted out.
Barry O’Dwyer concluded: “Auto-enrolment is a big step in the right direction towards helping people to save adequately for their retirement. But we must recognise that one size does not fit all. Some young people will have tough financial decisions to make, and will have to look at their priorities carefully. Making the decision with the right facts to-hand and a good understanding of the long-term implications of their choices are integral parts of financial planning for the future.”