The cost of living crisis has dominated headlines over the past year. Energy costs have soared, while inflation reached a 41-year high in October 2022.
As a result, it’s easy to see you may be looking for ways to cut costs and save some extra money. If you or a family member are concerned about your finances, it may seem tempting to reduce, or halt, your pension contributions for a time.
If you feel this way, you’re not alone. Aviva reports that roughly 23% of Brits who have a pension have been considering drawing money from their pension pot or are planning to reduce or halt their contributions altogether to ease financial pressure.
However, doing so could damage your long-term financial wellbeing and leave you with significantly less money during retirement, even if you pause contributions for just a brief period.
Here are three reasons it’s vital to keep up your pension contributions amid the cost of living crisis, and some things to consider if you do need to cut costs.
1. You won’t benefit from potential tax relief
Potentially one of the best things about making regular pension contributions is tax relief. Essentially, the government “tops up” your contributions when you deposit money into your pension pot.
This means that some money you would have initially paid in tax on your earnings instead goes towards your retirement.
As of the 2022/23 tax year, you can receive tax relief on contributions up to £40,000, or 100% of your earnings, whichever is lower. Then, the tax relief you’re entitled to depends on your marginal Income Tax band.
For instance, if you’re a basic-rate taxpayer, a £100 contribution would only “cost” you £80. The government would add an extra £20 on top of your contribution.
Meanwhile, if you’re a higher- or additional-rate taxpayer, a £100 contribution would only “cost” you £60 or £55, respectively. It’s important to note that you must claim this additional tax relief through your self-assessment tax return.
As you can imagine, if you pause, or even reduce, your pension contributions, you could lose out on the tax relief you would have received on these deposits. This means you’re basically giving up “free” money.
2. You could miss out on compound growth
Compound growth can see your savings snowball over the years.
For instance, if you invested £100 and received annual returns of 5%, you’d have £105 in a year. If this 5% return continues into year two, you’ll have £110.25, then £115.76 in year three. You’re essentially receiving “growth on growth”.
Even though you could save some money today by pausing or reducing your pension contributions, you could lose out on potential returns from the money you’re no longer investing.
To show how much of an effect compound growth can have on your total pension pot, Hargreaves Lansdown offers a valuable example.
Say you pay £100 into your pension, and you’re a basic-rate taxpayer; you’d have £125 after tax relief.
If this grows by 5% a year above inflation after charges, it would be worth about £540 in 30 years’ time. If you halted these £100 monthly contributions for a year, you would miss out on between £6,340 and £12,680 after 30 years if the 5% growth continued.
This would mean you’d need to work for longer to make up for the loss, or have to accept a lower standard of living in your retirement.
3. You could lose your employer contributions
If you’re in a workplace pension scheme, there’s a high chance your employer makes contributions to your pension pot on your behalf. In fact, by law, employers must pay 3% of your earnings in most cases.
If your workplace pension allows you to reduce or pause your contributions, and you do so to save money, you could forfeit your employer’s 3% contribution completely. This will essentially reduce your earnings by 3%.
For example, Standard Life reports that if you started working with a salary of £25,000 a year and paid the typical auto-enrolment contributions (you 5%, your employer 3%) from the age of 22, you would have £456,893 saved by the time you reach age 68.
However, if you stopped making contributions for just a single year, your total pot would reduce to £444,129.
Even by halting contributions for a single year, the fact you’d lost both your and your employer’s contributions mean you would have £12,764 less – you’re essentially losing out on “free” money.
Read on to discover some things to consider before you reduce your pension contributions.
Rework your budget
While you should always have a budget in place, regardless of economic conditions, it may be beneficial to sit down and review it before you think about reducing or pausing your pension contributions.
You may want to determine how your expenditure is increasing and establish where you can realistically afford to make cuts without reducing your pension contributions.
Speak with your employer
It may also be worth sitting down and talking with your employer about reducing your payments rather than stopping them altogether if you’re especially struggling.
You may find that your employer has other schemes and ideas available to you that could help you financially while protecting your contributions.
Speak with an adviser
Speaking with an adviser is perhaps the best way to manage your pension contributions during these uncertain times.
Together, you can work out how much income you’ll realistically need to achieve your dream lifestyle during retirement, and then establish how much you should be saving in order to reach these goals.
Get in touch
When times are tough, we can help you manage your money so you don’t need to reduce or halt pension contributions that could damage your future financial wellbeing.
Please email enquire@london-money.co.uk or call (0207) 808 4120 to find out how we could help you.
Please note
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.