Millions of workers auto-enrolled into pensions will see deductions from wages triple in April, squeezing their spending power and testing the commitment to saving for old age.
Only a relatively modest 0.8 per of pay packets is being diverted into people’s pensions to date, but this will jump to 2.4 per cent next month, followed by a further steep increase to 4 per cent the following year.
It will be a huge test for this so far successful experiment into ‘nudging’ workers to provide for their own retirement. Such a dramatic hit to their monthly income could well overcome people’s natural inertia and cause a spike in opt-outs.
Auto enrolment: Worker contributions will jump from 0.8 per cent to 2.4 per cent next month
For someone on average earnings of £27,000 a year, who contributes an annual £169 now, payments will rise to £517 from April, and £876 the year after, according to calculations by financial firm AJ Bell.
But those who can’t stomach paying this much or simply can’t afford it will forfeit free employer and Government top-ups – these will be going up too – and the potentially large sums that can be built up through investment growth over a working life.
We look at what is changing, who will be affected, and the financial consequences of a decision to opt out or stick with auto-enrolment pensions.
How is auto-enrolment changing in April?
The auto-enrolment programme kicked off in 2012 with just small and optional wage deductions of 0.8 per cent from workers. Employers are compelled to pay larger contributions of 1 per cent, and are not allowed to deter staff from taking part.
The Government throws in pension tax relief of 0.2 per cent, bringing total contributions to 2 per cent of eligible earnings (see the box below) at present.
How does auto enrolment work?
Workers aged between 22 and state pension age and earning at least £10,000 a year from one job are now automatically signed up for a pension, unless they make an active move to opt out.
The slice of annual earnings used to determine the amount of contributions that ends up in someone’s works pension fund is currently between £5,876 and £45,000, but this will change to between £6,032 and £46,350 from 6 April.
This is the minimum, but some employers choose to be more generous.
Being self-employed, earning low wages, only working part-time, holding down two jobs that both pay less than £10,000, and being too old or young are among the main reasons that make people ineligible for auto enrolment into a workplace pension scheme.
Last year the Government announced plans to extend auto-enrolment to 18 to 22-year-olds and low earners, and explore ways of encouraging the self-employed to save for retirement, but postponed any changes until the mid 2020s.
This tentative start is arguably why most workers were inclined to go along with the initiative, which wasn’t assured of success at the time although it is widely hailed as a triumph now.
But the plan was always to increase contributions, since 2 per cent is considered a good start that at least got many people saving for retirement for the first time, but insufficient to provide for a comfortable old age.
Around nine million people and one million employers have taken part in auto enrolment, and will potentially be hit by the increases.
However, many employers and employees already pay pension contributions above the new auto-enrolment minimums, and they won’t be affected.
The current and future levels are given in detail in the table below, but basically total contributions are rising to 5 per cent of eligible earnings from this April and 8 per cent from the April after that.
Will people ditch auto enrolment?
Poorer workers facing big increases in pension contributions will face a serious dilemma.
The headline 2.4 per cent figure disguises the reality that people on the lowest earnings will take a much bigger proportional hit to their take-home pay than those on better salaries.
The financial benefits of sticking with auto-enrolment are gone into in full below. But some workers will have no choice but to opt out, because the need to buy food and keep a roof over their heads will very understandably take priority over long-term saving into a pension.
The auto-enrolment system is all in or all out, if you want to be sure of getting free employer contributions into your pot.
Some employers are more generous and choose to contribute anyway – and above the minimum level. But if yours does not, you will have to pay in more from April, because there is no option to stay in at the old 0.8 per cent level and still benefit from compulsory employer top-ups.
Who pays what? How pension contributions stack up under auto-enrolment schemes (Source: The Pensions Advisory Service)
Some have asked whether the rules really have to be that rigid, but so far the drive to get people saving at a higher rate that’s more likely to give them a decent retirement – and avert a pensions crisis as generous final salary schemes are phased out – has won the day.
Pension experts have tended to push the view that even 8 per cent of salary falls woefully short, and total contributions really need to be 15 per cent of salary.
That said, if people start ditching their auto-enrolment pensions in droves, then allowing people to remain in the system at different contribution levels might be looked at again.
Politicians, officials and the pensions industry regard the April increase as a big test of auto enrolment, and will be keeping a close watch on opt-out levels. It’s not in anyone’s interest to let a crisis blow up in a programme that’s been so successful to date.
One worry is that many workers are probably unaware their pension contributions will suddenly be hiked by so much, and will only find out when they start getting pay statements from April onwards. The shock factor alone might prompt opt-ups.
The Pensions Regulator says that although it’s not a legal requirement, most employers intend to write to their staff about the increase. It has created a template letter explaining the changes for them to send. You can see a copy below.
What if people go along with the pension increase?
There might also be fallout if people stick with auto enrolment en masse. The higher contributions will hit their spending power, with potential knock-on effects for economic growth.
The Office for Budget Responsibility said in its latest economic outlook that household disposable income growth is expected to fall back slightly in 2019 as average earnings growth slows.
What does the OBR say about auto enrolment?
‘When forming our judgement about the path of household consumption growth, we have generally focused on a measure of saving that excludes pension contributions, as many of these – such as employers’ contributions – are often largely invisible to the employee in real time.
‘Auto-enrolment in workplace pensions may, however, make workers more aware of their own saving towards a pension and the contributions of their employer and of the Government.
‘So they may be more likely to take them into account when making spending decisions.’
It put this partly down to ‘higher pension contributions as auto-enrolment expands and minimum contribution rates increase’.
Also, the Government is already putting its hand in its pocket for more pension tax relief as people save bigger sums for retirement.
In January, it emerged that the total cost of pension tax relief – including rebates on personal contributions, not levying employer NI on their pension contributions, and other tax breaks – has risen to around £55billion a year.
While more people being able to fund their own retirement benefits the Government in the long run, the necessarily more short-termist politicians in power now are bound to fret about the rising cost of supporting auto enrolment.
Former Pensions Minister Steve Webb, now policy director at Royal London, says: ‘The Treasury will no doubt be studying the rising cost of pension tax relief with great interest.
‘The worry is that they will be tempted to use pension tax breaks as a “cash cow”, useful for dipping into whenever they are short of money.
‘Pension tax reliefs have been “salami sliced” six times since 2010, with cuts to both lifetime and annual allowances. Every time this happens it adds complexity and reduces long-term trust in the system.’
Former Chancellor George Osborne toyed with the idea of a major cost-cutting overhaul of pension tax relief but ultimately backed off. The current Government doesn’t seem minded to revisit the idea, at least not yet.
But it’s inevitable the Government will look again at cutting the pension tax relief bill if it gets too out of hand, even if it’s just through more tinkering with allowances rather than a huge shake-up.
What is the impact for workers of opting out versus sticking with pensions?
Pension industry number crunchers have worked out the cost of pending increases for average earners, what would happen to pots if total contributions stayed at 2 per cent, and size of eventual funds if you go along with the changes.
AJ Bell says that someone on an average UK salary of £27,000 a year is currently contributing £169 to their pension under auto enrolment. Assuming they get an annual pay increase of 2 per cent, this will rise to £517 next month, and £876 in April 2019.
‘If auto-enrolment contributions stayed at their current level, someone on an average salary of £27,000, increasing by 2 per cent a year, would build a pension fund of just £56,965 over a 40 year career,’ says the firm.
‘With the increases in contributions over the next 13 months, that figure could soar to £218,791, an increase of £161,826.’ See the table below.
Changes to minimum auto-enrolment contributions for three starting salary levels and the difference in fund value after 40 years if contributions were not increased
Number crunching: The calculations are based on current eligible earnings for pension contributions under auto enrolment of between £5,876 and £45,000. *Including employer contributions and Government tax relief. **Assumes 4% investment growth after charges.
Fidelity International looked at what consumers would get if they maintained their current saving levels versus increasing their contributions.
It says the assumptions are based on a person aged 33 when they start saving. They save for 35 years to age 68. Earnings increase at 3.75 per cent a year and investments grow at 5 per cent a year. The starting salary is £35,000.
Fidelity calculates that if the current level of 2 per cent contributions was maintained, someone in the above circumstances could build a pension pot of £94,092 by the time they reach retirement.
But under the 5 per cent contribution level from April, they could build a pot worth of £235,229. And under the total contribution rate of 8 per cent from April 2019, the saver in this scenario could reach a pot of £366,445 – nearly three and a half times what they would get if total contributions stayed at 2 per cent.
What does the pension industry say?
‘These increases are significant but investors should resist the urge to opt out of their workplace scheme because the increases are essential to ensuring they have adequate pension savings,’ says Tom Selby, senior analyst at AJ Bell.
‘As well as personal contributions increasing, people will also get more from their employer and the Government in the form of tax relief so the overall impact on their fund size can be significant over their career.
‘Anyone considering about opting-out needs to think long and hard about what it will mean for their long-term retirement prospects.
‘People who do quit their workplace pension are likely to be tens of thousands of pounds worse off over their career and face living on the state pension, which is currently worth under £160 a week.’
Tips for workers coping with the April pension increases
Sanlam UK offers the following advice to savers.
* Have you budgeted for the April increase in your pension contributions from at least 1 per cent to 3 per cent of your earnings?
* Are your contributions based upon basic salary, qualifying earnings, or total earnings? You will need to know this in order to calculate the additional cost to you.
* You may wish to speak with your employer in advance of April if you don’t feel that you can afford the increase – they may decide to stop their contribution if you can’t pay the higher percentage.
* Check the current value of your pension plan, as this will demonstrate how valuable auto-enrolment has been to you.
* You also need to budget for the next increase that takes place in April 2019 at which point you will need to be paying 4 per cent of your earnings whilst your employer will need to contribute at least 3 per cent with the Government adding another 1 per cent.
Elliott Silk, head of commercial at Sanlam UK, says: ‘More needs to be done by employers and the government alike to ensure all the hard work is not undone by inertia.
‘What we don’t want to see is people waking up and questioning why their pay cheque is less than last month without having prior knowledge of the increase.
‘If we provide people with information ahead of the deadline, we can help them realise the value of these contributions and the impact they could have on their future lives in retirement.
‘There is also an opportunity to educate people on the true cost of retirement, and while automatic enrolment is helping more people to save, the reality is that the contribution levels are still some way off the amount required to live a comfortable lifestyle in retirement.’
Nathan Long, senior pension analyst at Hargreaves Lansdown, says: ‘Pay packets are already stretched to near breaking point for many up and down the country, so there will be much nail biting ahead of hikes to minimum pension contributions in April 2018 that the Government’s flagship auto-enrolment initiative is not derailed.
‘Latest data shows there is appetite for pension saving with those in the public sector already paying in excess of 5 per cent for their pensions.
‘Whilst they benefit from a government backed promise, a small charm offensive from private sector employers about the benefits of saving for retirement could be enough to allay concerns of any looming auto-enrolmaggedon.’
Carolyn Jones, head of pensions product at Fidelity International, says: ‘Recent commentary has focused on what consumers stand to lose next month and we need to turn this way of thinking on its head.
‘Auto-enrolment was a water shed moment as it changed the dial from “do nothing, get nothing” to “do nothing, get something”.
‘Saving for retirement is no longer an option – it is an essential period of life to plan for as the state begins to tussle with the challenges of an ageing society.
‘We cannot forget that auto-enrolment was always viewed as achieving the bare minimum for private pension saving, a baseline on which to build additional saving.
‘Opting out come April 2018 will see a loss of valuable employer contributions that they, quite simply, cannot get elsewhere. Any short term cost saving now will shrink in light of the valuable benefits you could have had later.’
Employer letter to workers about auto enrolment
Template: The Pensions Regulator has suggested employers send the letter above to their staff
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