The cost-of-living crisis has prompted more young workers to opt out of their workplace pensions, forgoing contributions from both their employers and the government. According to investment platform AJ Bell, 34% of workers have opted out or are considering doing so, a figure that rises to 47% for 18- to 34-year-olds.
This is the opposite of what this week’s Pensions Awareness campaign seeks to achieve. Ideally, halting pension contributions should only be a last resort given the matching contributions from your employer and the government. Yet tough economic times mean that more people, especially the young, are doing precisely that.
This is not a decision to be taken lightly, but if the alternative is escalating debt, temporarily suspending your contributions might be the least-bad option.
Ten years ago, opting in was the default option for workplace pensions. In 2012, in an effort to increase pension participation, the government introduced a subtle legislative change that made opting out of an employer’s pension scheme the default option. Nobody was forced to participate, despite the obvious financial advantages, but if people didn’t want to be involved, they had to consciously leave the plan.
By any objective measure, this has been a tremendous success. When the pandemic struck in 2020, more than 90% of eligible private-sector workers in the UK were members of workplace schemes. It’s not hard to see why: Even on the minimum setting, an employee’s contribution of 4% of eligible earnings is matched by a further 3% from their employer and 1% of tax relief from the government. Many employers even offer to match their employees’ contribution to higher levels, so it is a significant decision to forgo this “free” money.
But that is what workers are increasingly doing, pressured by the short-term imperatives of feeding their families and heating their homes.
If you are faced with such a decision, the first thing to do is to understand what is at stake and what you might stand to lose. At a minimum, if you stop contributing to your pension, you will lose the match from your employer and the government. Look closely at the scheme you are planning to leave. Many employers contribute more than the 3% minimum.
If you still conclude that, after paying for life’s essentials, making pension contributions will push you further into debt, then it might be sensible to consider temporarily suspending your contributions while you clear your liabilities. You can, after all, opt back in any time you like.
This makes even more sense if, as tends to be the case with those facing financial distress, the cost of borrowing is high. With incomes failing to match the increased cost of living, expensive debt is to be avoided at all costs and paying down balances should become the priority.
I described a number of strategies for coping with debt here, including the avalanche method of paying off the most expensive debt first and the snowball method, which involves cleaning up smaller loans and working upwards. Remember too that you don’t have to do this alone. Services like Money Helper, which provide free support on a wide range of financial issues, can guide you.
A parallel issue facing workers is that those older than 55 have been drawing more down from their pensions than in the past, often in lump sums and frequently while they are still working. Those flexibly withdrawing from pension plans jumped by 23% in the second quarter of 2022 compared to a year earlier. It’s impossible to say exactly what the money has been spent on, but it’s easy to imagine that at least some of it has gone to rising bills and mortgage repayments.
This is another aspect of short-term financial imperatives trumping long-term tax and savings benefits. Such withdrawals are clearly not financially sustainable, but make sense if the alternatives are more expensive. One of the key issues with pension withdrawals, however, is to ensure that you don’t pay more tax than is necessary.
Withdrawals are tax-efficient, but they are not tax-free. Once you reach the age of 55, it is usually possible to withdraw 25% of your pension pot free of income tax. Any drawdown beyond that is taxed at your marginal income tax rate, which can be up to 45%. Added to which, drawing down more than 25% to meet a temporary commitment might severely limit your options to replenish your pension pot should things improve. The annual pension contribution allowance is £40,000 ($46,412), but drops to just £4,000 if more than the tax-free sum had already been withdrawn.
If you’re struggling, it’s generally better to first tap your savings and investments before reaching into your pension pot. You can withdraw from your ISA savings tax-free, and it won’t impact potential future retirement savings. If pension withdrawals remain your only option, straddling them across the financial year-end in April might be more tax efficient, allowing you to offset the annual £12,570 income tax allowance twice (once for each tax year) against any withdrawal.
Halting pension contributions, or prematurely withdrawing from your pot, is far from ideal, but it may make sense if maintaining your pension has become unaffordable. Yet in such straightened circumstances, it is even more critical to do things as efficiently as possible, while taking advantage of the free help that is out there, not just as part of Pension Awareness Week, but on an ongoing basis.
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