Watch out in case your employer dumbs down your pension

11th January 2013

Auto-enrolment will certainly get more people putting money away for their retirement, but for some employees building up a decent pension pot may prove even more difficult in future than it is now. Pensions journalist John Greenwood considers the issues.

This is because some companies that currently offer more than the legal minimum required under the government’s new auto-enrolment policy will be cutting back the employer contribution they make into employees’ schemes.

Pensions experts say all staff enrolling into schemes at the auto-enrolment minimum, which will be 8 per cent of earnings above £5,564 once the scheme is fully up and running, need to understand it will not on its own be enough to give them the retirement income they want or expect.

It is easy to see why employers would want to scale back their contributions. Many workplace schemes have low take-up amongst staff who are often deterred by the fact that they have to contribute from their salary to benefit from their employer’s contributions.

If a scheme only has 50 per cent of employees as members before auto-enrolment but that increases to 80 per cent of employees after auto-enrolment (if 20 per cent of staff exercise their right to opt out again), then the employer’s payroll cost of pension contributions increase by 60 per cent.

To combat this extra cost some schemes that currently pay more than the legal minimum are looking to scale back contribution rates.

A recent survey by consultants Aon Hewitt found one in three employers are looking to save money by reducing contributions to the legal minimum for auto-enrolment. Most are planning to do it for people joining schemes for the first time, but some are even planning cuts for those already enjoying higher contributions.

The new auto-enrolment rules require all employers to automatically enroll staff into a pension scheme, deduct a pension contribution from their employee’s pay packet and also make an employer’s contribution on their behalf.

The process is being phased based on the size of employers. The very biggest employers began enrolling staff in October 2012. Over the next four years the employer obligation to pay into a pension will move right down to the smallest chip shop owners, hairdressers and nannies, who will have to enrol their staff in 2017.

Once everyone is enrolled, employees will pay in 5 per cent, including tax relief and a further 3 per cent will be paid into their pension pot by their employer. But until 2017, contributions will only be 1 per cent, including tax relief, from the employee and 1 per cent from the employer.

And these minimum contribution levels do not even apply to all of your earnings, but instead apply to those earnings between £5,564 and £42,475. So that means even when auto-enrolment is fully up and running with its 8 per cent combined contribution rate, in real terms that will be just 4 per cent of earnings for someone earning £11,000 and 6 per cent for someone on £22,000.

Experts say individuals need to start saving early if they want to build up meaningful pensions, and if they have already left it late, then need to pay in more and retire later if they are to have any hope of a decent retirement income.

A 30 year-old earning £35,000 making total contributions of 8 per cent of all earnings could expect a pension of £7,800 a year by age 65, assuming no tax-free cash is taken. If he or she leaves it another 10 years to start saving then the same contributions would deliver just £4,700.

By the age of 45, that 8 per cent contribution will deliver just £3,400, and falls to £2,300 for someone starting to save at 50. But by working until age 70 and increasing contributions by another 5 per cent, that 50-year-old can increase their likely pension income to a more meaningful £6,500. The same increases in contributions and retirement age will more than double the 45-year-old’s income to £8,800.

The older you are when you start and the lower the contributions being paid, the less worthwhile the whole thing can seem.

For example, if you are over 50 and being automatically enrolled into a scheme at the minimum 1 per cent employer, 1 per cent employee rate, you may think the income you would get will be so low as to make it not worth bothering. If income was your only option, you would be right – a 60-year-old on £25,000 automatically enrolled today at the minimum contribution rate would expect to build up a pot of around £2,500 by age 65. This princely sum would deliver a projected income of barely £2 a week for life – barely enough for a packet of Werther’s Originals, let alone a drink in a pub.

But it is not all a complete waste of time because people who reach retirement with small pots – which means anything up to £18,000 – are allowed to take it all as a cash lump sum, a quarter of it tax-free. £2,500 may not sound a lot for five years’ saving, but on the other hand half of it will have come from tax relief and the employer.

So if you have left it late to start saving so your pension pot is likely to be a small pot, then its best to think of auto-enrolment as the best value medium-term savings product on the market. And if you are in the small pension but not small pot bracket, upping your contributions and pushing back retirement are two key options.

John Greenwood is a pensions journalist and author of the Financial Times guide to pensions and wealth in retirement

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