Should I pause my pension to get me through the cost-of-living crisis?

Various research studies have found a notable uptick in people withdrawing from their workplace pensions to help them through the cost-of-living squeeze. Is this a wise step?

It could be said that we’re all feeling the pinch – and, perhaps most discouraging of all, we know the cost-of-living crisis will get worse before it gets better. Inflation is already in double figures and last month the Bank of England predicted it will exceed 13% by the end of this year. Other economists, such as at US bank Citi, think inflation could peak as high as 18% at the beginning of next year.

Despite most people’s energy bills having already been spiralling upwards for much of the last year, the cap on variable or default energy tariffs will jump again in October – from £1,971 to £3,549, an 80% leap – before facing yet another rise in January. Experts at consultancy Auxilione* issued a stark warning that the energy cap could reach £7,263 in April next year.

Needless to say, many people are keen to identify ways in which they can pull back on non-essential purchases to ease the impact of soaring energy bills and, where possible, limit the effects of inflation on their lifestyle. In some instances, however, the cost-of-living squeeze is causing people to take the drastic step of withdrawing from their workplace pension scheme.

Pause for thought

A spate of recent studies has laid bare this concerning trend which a small but sizeable group of workers are resorting to in order to free up funds. According to research by Canada Life, 5% of adults have already paused their pension contributions and a further 15% are considering it. Charles Stanley discovered even steeper results, with its own survey finding that a quarter of employees had either already withdrawn from their workplace pension or were considering it.

Analysis from pensions provider Penfold, meanwhile, revealed that the number of people opting out of their workplace pension scheme increased by 29% between March and July. This data comes from Penfold’s customer base, which is composed of 5,027 onboarded employees.

Stopping contributions to your workplace pension is undoubtedly a fast, easy route to reducing your monthly outgoings in the short term, and it might seem like a pause of only one year would have a negligible impact on your overall pension pot when you retire, but that’s not the case. The impact of pausing your pension contributions even for a short period can have a significant impact on your retirement income, especially if you are earlier in your career.

This is because of three major factors that make pensions such an attractive form of saving for retirement in the first place. Firstly, if you withdraw from your workplace pension scheme, your employer could also stop contributing to your pension. This means you are effectively taking a voluntary pay cut. Secondly, you miss out on very favourable tax relief on pension contributions – which is 20% for basic rate income taxpayers and 40% for higher-earning income taxpayers.

Thirdly, you will lose some of the impact of your pension’s best friend: compound interest. Described by Albert Einstein as “the eighth wonder of the world”, compound interest means you earn interest on the interest that has already been built on your pension savings. As it accumulates over time, even small pension contributions can eventually grow into large sums. Investment involves risk.

Don’t look back in anger

What does that mean in practice? Canada Life did some sums as part of its research and found that opting out of a workplace pension for just a year could reduce the value of an average final pot by 4%, all other things being equal. A 40-year-old earning £50,000 a year who paused contributions of 8% for a year would have £15,000 less in their pension when they retire at 67.

The impact, of course, is larger the younger you are and the longer you decide to pause your pension contributions. Penfold calculated that a 20-year-old who contributes £200 a month but then pauses contributions for three years would see the final value of their pension pot reduced by £28,074, from £268,675 to £240,600, representing a decrease of more than 10%. The calculation assumed a retirement age of 67 and a modest annual growth rate of 5 per cent.

Analysis by AJ Bell, meanwhile, showed that a 30-year-old with a £30,000 salary, who normally pays 5% while their employer contributes 2%, would miss out on £5,847 of contributions if they pulled out of their workplace pension for three years and received a 2% pay rise each year. While that might not sound like a huge hit on a total pension pot, annual investment growth of 4% and compound interest would see it grow to £24,954 when the 30-year-old retired aged 68.

“It’s the early premiums that are going to grow the most,” says Kevin Clare, Independent Financial Adviser at Ascot Lloyd. “The premiums you pay in your 50s and 60s don’t get as much of a chance to grow before you retire, though the compounding interest is still hugely valuable at this age along with pension tax relief and employer contributions. The contributions into your pension in your 20s and 30s, however, are going to catapult your income in retirement.

“Even though it might seem like you’re only dropping a small amount from your pension by pausing it for a year, it could have a detrimental impact on your finances in retirement, and you don’t want to look back wishing that you had tried to save money elsewhere. Any decision which will impact your long-term financial future should be taken with caution, and this is certainly one. A conversation with a financial adviser would help massively.” Investment involves risk.

Alternative steps

There are alternative methods to reducing expenditure through the cost-of-living crisis, including spending less on non-essentials, using less gas and electricity at home by, for instance, wearing warming clothing or turning lights off, and cutting back on journeys you do not necessarily need to make. Pension contributions are vital and should never be seen as a non-essential expense.

Ascot Lloyd has cash flow modelling tools which its independent financial advisers use to assess their client’s income and expenditure and identify effective ways to reduce the latter while still meeting your financial objectives. If you do require additional income, there are also potential levels that can be pulled to release funds in the short term without damaging your long-term financial plan. The months ahead may be challenging, but your Ascot Lloyd Financial Adviser will help you plan effectively through high inflation while also supporting your family if required.

To discuss ways to ease the financial strain on you or your family during the cost-of-living crisis, please contact your Ascot Lloyd Financial Adviser in the usual way or get in touch here.

*Source - Independent article 'No new taxes': Liz Truss ties her hands over funding energy crisis bailouts' Published 01 September