If you are paying high interest on credit card debt does it makes sense to use every penny possible to reduce your debts? You certainly shouldn’t have a lot of savings whilst you are in debt, but there are many good reasons why you should continue to make pension contributions:
Most people making pension contributions will have these increased by employer’s contributions and tax relief.
If your employer is ‘matching’ your contributions and you are a basic rate tax payer, a pension contribution that will cost you £100 results in a total amount of £225 going into your pension. That is a huge increase, much larger than the interest that you credit card is incurring. Your employer is effectively giving you free cash!
If you are in a defined benefit pension, such as final salary or a career average scheme, it isn’t as obvious how much is being added, but the costs of these sorts of schemes are usually higher so your employer is contributing even more to them.
If you are getting any means-tested benefits such as tax credits, housing benefit or Universal Credit, then you usually also “gain” through contributing to your employer’s pension because although the contribution reduces your salary, you will get higher benefits, see the February 2016 report The effect of taxes and charges on savings incentives for details.
Many employers are closing defined benefit schemes to newcomers because they are too expensive for the employer – which means they are very beneficial for you! You should not opt out of one of these schemes as it may not be possible to opt back in again at a later date; you might have to join a less desirable defined contribution scheme.
The other problem with opting out of a pension to clear your urgent and expensive credit cards and loans is that you may not opt in again at the end. When your debts are all paid off, it may seem that your most urgent need is to save for a house deposit and then along come children … twenty years pass before it next feels as though you can easily afford to put money away for your old age.
There is a neat video here that demonstrates just how disastrous this can be for your pension – saving a small amount regularly throughout your life is much more beneficial than saving a lot later as you gain from compound interest.
For most people it is never easy to ‘spare’ the money for pension savings and it is too tempting to deal with your current problems – your debts – and not think about the negative effect this may have on the twenty or thirty years you could be retired for.
So is it ever right to stop paying in?
This is ultimately a decision that you have to make – there is no absolute right or wrong. However, I would suggest as a general rule that you should always aim to make at least the contributions needed to get the maximum contribution from your employer.
If you are currently paying in more than this, then you could consider reducing your contributions and use the freed-up money to pay off your debts faster. But
- don’t do this before looking at what your other alternatives are… look at other ways of improving your finances by spending less or earning more. If cutting back on take-aways and Sky, or getting a lodger for a few years is possible, then it would probably be a mistake to take the ‘easy’ option now of cutting your pension contributions – you are going to be retired for a very long while and who knows what the state pension will be like when you get to that age!
- set a time limit – a year or two years perhaps – at the end of which you will resume your current levels. Make this a definite decision to avoid the trap of always putting them off for another year.
If you are self-employed you have more freedom over what you pay into your pension. But without the incentive of an employer offering you a carrot to contribute, this freedom can be a curse. You should probably be thinking of 8% as the bare minimum of savings – this is the equivalent of what a worker will have paid in if they are in ‘auto-enrollment’ in a couple of years time.
What about taking money out of a pension to pay debts?
From April 2015 if you are over 55 you may now be able to take out some or all of your pension money. But this may not be a good idea when you look at the tax costs, charges and effect on any benefits – see Should I use Pension Money to pay my Debts? for more details.