November 26th, 2020
Why you shouldn’t let the pandemic affect your pension contributions
The economic crisis caused by the coronavirus and the subsequent lockdowns has had a significant effect on many people. As a result, millions of Brits have cut back their pension contributions as they feel a squeeze on their household finances.
However, while it might be tempting to cut back on your pension contributions to have more money in the short term, it can have a significant impact on your finances and quality of life in the long term. Read on to find out why you shouldn’t let the pandemic affect your pension contributions.
Around 2 million Brits are currently furloughed on reduced income
The lockdowns caused by the pandemic have caused many families in the UK to have to tighten their belts. According to the BBC, around two million Brits were furloughed at the end of October 2020, meaning that many households are having to make ends meet with a reduced income.
This has caused many people to reduce their pension contributions without considering the full consequences of what effect that may have by the time they retire.
Source: This is Money
According to a recent survey by pension firm Hargreaves Lansdown, published in the Telegraph, one in four people have said they have either reduced their monthly pension contributions or stopped contributing entirely.
As you can see from the chart, the people who are most likely to reduce or stop their pension contributions are young adults. This might be understandable, as they may be less likely to have a well-paying job early in their career and may be more vulnerable to financial shocks.
However, the younger you are, the more impact that a halt or reduction in contributions can have on your pension fund when you come to retire. This is due to the effects of compound interest.
Halting your pension contributions can have a significant effect over time due to compound interest
Albert Einstein once referred to compound interest as the ‘eighth wonder of the world’. When you understand the effect it can have on a long-term investment like a pension, you might be tempted to agree.
Typically, if you’re saving for your retirement, most financial planners will recommend that you start as soon as possible.
Obviously, one reason for this is that you will have longer to make contributions, but another reason is that your contributions will compound. This means that you will benefit not only from the returns on your contributions, but also on the growth on the returns.
Because of the effect of compound interest over a long period of time, younger people can be significantly affected if they halt or reduce their pension contributions. This is because even a small contribution can add up to a significant amount if left to accrue compound returns for several decades.
Halting your pension contributions will mean you lose your employer’s workplace contribution
Another reason not to reduce your pension contributions is that by doing so, you may lose the contributions that your employer makes on your behalf.
Auto-enrolment in workplace pensions has been in place since 2012 and, unless you’ve opted out, you should be enrolled in a workplace pension scheme. The minimum contribution in such schemes is typically 5% of your salary, but this is topped up by an additional 3% paid by your employer.
This means that if you halt your pension contributions by opting out of your workplace pension you are not only losing your own contribution but also that of your employer.
For example, if you had a salary of £24,000 per year, then your qualifying earnings for working out your pension contributions would be £17,760. This is worked out as your salary before tax, minus the lower earnings threshold of £6,240.
With this level of qualifying earnings, you would contribute £888 per year to your pension (5%) while your employer would pay in an additional £532.80. This means that if you halted your pension contributions, you would lose that £532.80 that your employer was contributing.
Remember also that the effect of compound growth on your employer’s contribution can add up to a significant amount over the long term.
Taking even a short pension contribution holiday can have a significant impact on your lifestyle in retirement
While reducing your pension contribution may seem like a good way of easing the strain on your finances in the short term, it can have a disastrous effect on your quality of life in retirement.
According to a 2020 study by consumer advice group Which?, the average comfortably retired household spends around £25,000 per year. Since the State Pension is only around £9,000 (2020/21), it will be up to you to make up that difference with your private pensions. Failing to do so could mean you have to live a much less comfortable lifestyle in retirement than you might have hoped for.
Due to the effects of compound interest, taking even a year’s worth of pension contribution holiday can have a significant impact on the amount of money in your pension fund.
This is why, if you’re struggling to make ends meet, cutting back on your pension contributions should be one of the last things you consider.
If you’re struggling financially, you may benefit from speaking to a financial adviser, who can help to ensure that you can meet your financial goals and won’t have to sacrifice future comfort for current convenience.
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