If you are paying high interest on credit cards or other debts should you 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.
Nearly 10 million people have started saving money into their pension since auto-enrollment came in, where employers have to make a contribution too. Most employers and workers only pay in the minimum amounts.
Before April 2018, your minimum would have been only 1% – that would never add up to any amount of pension worth having, so the intention was always to increase it in two steps.
In April 2018 your minimum contributions went up to 3%. And they will be going up again to 5% in April 2019.
At the same time your employer is adding more and the tax back that is going into your pension pot is also going up. So that’s good… but you may be wondering if you can really afford to pay in 5%.
Three reasons to continue paying into a pension (or start if you have currently opted out!)
After April 2019, if you and your employer are paying in the minimums and you pay basic rate tax, a contribution of £200 from you has added £150 from your employer and £50 by HMRC – a total of £400. So your money is doubled.
That is a huge increase, much larger than the interest that your 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 benefits such as tax credits, housing benefit or Universal Credit, then you usually also “gain” through contributing to your pension. Although the contribution reduces your salary, this means your benefits go up a bit. See this 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 much less good 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.
For most people, it is never easy to ‘spare’ the money for pension savings. It is too tempting to deal with your current problems – your debts – and not think about the negative effect later on. But you be retired for twenty or thirty years – this is a long period of your life and you want it to be as comfortable as possible. Who knows what the state pension will be like when you get to that age?
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 pay in enough to get the maximum contribution from your employer. Don’t turn down this tax-free handout!
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 takeaways 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.
- 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.
Delaying makes it much harder to get a good pension
By starting young, you get compound interest working for you. Those early savings are going to have a lot more interest added than later ones.
As a rough rule, if you start saving a set amount aged 25 and carry on paying that for 40 years until you retire, you would have to pay 50% more a month if you don’t start until you are 35, when you only have 30 years left.
And if you delayed until you were 45, you would have to save nearly twice as much a month to get the same pension.
What if you are self-employed?
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 turn out to 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 be paying in if they are in ‘auto-enrollment’ from April 2019. A commonly quoted rule is that the percentage you should be saving is half your age. So aged 28 that would be 14%.
What about taking money out of a pension to pay debts?
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.