Why stopping pension contributions to ease the cost of living crisis could be a big mistake, warns ex-Pensions Minister Steve Webb

As energy bills, fuel and food costs soar, you may be thinking about stopping your pension payments or even raiding your pot if you’re over 55. But before you do, think carefully, writes Steve Webb, the former pension minister and partner at consultants Lane, Clark & Peacock (opens in new tab).

With household budgets being squeezed more every week, it is entirely understandable that people are looking for ways to save money or find some money to pay for bills. In particular, some may be tempted either to opt out of their current workplace pension, or to dip into pensions which have already been built up. There may indeed be situations in which this would be the right thing to do. But there are important things to be aware of before you make such a decision.

SHOULD YOU STOP PENSION PAYMENTS?

Starting with workplace pensions, millions of us have been ‘automatically enrolled’ by our employer into a workplace pension. Unless we opt out, money is deducted from our pay and put into a pension. This is topped up by a tax break from the government and a contribution from our employer.  

One way of saving money would be to opt out of our workplace pension in order to give us a bit more take-home pay. But it is important to realise that if you do opt out you lose something which can’t be replaced – the money your employer would have paid into your pension. If you stay opted out for more than a very short period of time you will start to find it increasingly difficult to build up a decent pension for your retirement. 

To give a simple example, someone may be paying £800 per year out of their take-home pay into a workplace pension. Assuming they pay tax at the basic rate, HM Revenue and Customs (HMRC) will top this up by adding £200, whilst their employer will add another £600. In other words, something which costs you £800 ends up as £1,600 in your pension. If you opt out, you save the £800 per year, but your pension ends up £1,600 per year lower. This is not a great choice if you have other options for saving money.

SHOULD YOU ACCESS YOUR PENSION POT EARLY?

For those who are a bit older, a different way of dealing with the cost of living crisis might be to tap into pensions they have already saved. This is usually possible once you have reached the age of 55 or above. But again there are several things you need to think about before you take such a step.

The first is the tax implications of accessing your pension. Although you can usually take 25% of your pension pot tax-free, the rest is subject to income tax. If you are in work when you dip into your pension in this way, you will probably already be paying tax, and the remaining 75% of your pension withdrawal will be taxed in full, possibly even at the higher rate. This is likely to mean that you pay a lot more tax on your pension savings than if you were able to put off tapping into your pension until you were no longer in work.

Another important tax point to be aware of is that when you first access a pension, HMRC has to decide how much tax to deduct. Slightly bizarrely, they work on the assumption that you will be repeatedly accessing your pension all through the tax year, and as a result they may tax you as if you were a lot wealthier than is actually the case. This can leave you with a lot less in the bank than you expected after your first pension withdrawal. Although you can claim back the excess tax, this can take some months, so if you are in urgent need of cash you need to factor this in.

In addition to all of this, once you take some taxable cash out of your pensions, HMRC then imposes a strict limit on how much you can pay into a pension in future whilst still benefiting from pension tax relief. Under normal circumstances you can contribute up to £40,000 a year into a pension and still enjoy tax relief on your contributions. But as soon as you have taken taxable cash out of your pension, this annual limit slumps from £40,000 to £4,000 – a limit known in the jargon as the ‘Money Purchase Annual Allowance’. To put it in simple terms, if you access your pension now because you are short of cash, you may find it much harder in future to build it back up again.

Money inside your pension pot is invested and will generally grow year-by-year. The power of compound interest means that money you leave in your pension pot will earn a return and that return will earn a further return and so forth. As a result, taking one pound out of your pension now may damage your final pension pot by much more than one pound.

So, if it is best to avoid giving up on pension saving, and if it is best to avoid raiding your pension pot prematurely, what else can you do? One thing would be to draw first on any other savings you have which are not working as hard as the money in your pension. An obvious example would be money held in things like cash ISAs, premium bonds or even current accounts. Although a pound taken out of an ISA is a pound less for later in life, the chances are that the interest rate on your ISA is far lower than the rate of return on your pension. So you will do less damage to your long term prospects by tapping into low-return forms of saving first rather than raiding your pension.

As I said at the start, there may be times when stopping saving into a pension or tapping into a pension you have already saved is the best or even the only thing to do, especially if you are under financial pressure. But if you can find other ways of saving money or can access lower return forms of saving first, this is likely to mean that you do less damage to your prospects for a comfortable retirement than if you give up on pension saving.

Steve Webb is a partner at consultants Lane, Clark & Peacock and was Pensions Minister 2010-15