In the current cost of living crisis, some employees are tempted to opt out of their workplace pension scheme to boost their take home pay.
This is worrying because the reality is that opting out may be the costliest decision they ever make.
Let’s be clear, putting food on the table and maintaining a home must take priority over saving for retirement. However, opting out may not result in the increase in take-home pay one might envisage and may cost thousands of pounds in the longer term.
Why employees opt out of saving in their pension
We are all free to opt out of saving in our employer’s pension scheme. The most common reasons given for doing so are:
- Financial constraints: the employee is currently facing financial difficulties and feels their regular pension savings would be more useful in their take-home pay.
- Competing financial goals: the employee wishes to prioritise how their money works for them. For example, prioritise paying off debt or saving for a home.
- State benefits: the employee believes saving for retirement will reduce their current and/or future benefits.
- Ethical and religious grounds: the employee wants their pension savings to be invested in line with their ethical, moral, and/or religious beliefs.
- Already saved enough: some older employees believe they already have sufficient retirement savings and/or investments to pay for their lifestyle in retirement.
To explain the implications of opt out it is first necessary to understand what is being saved and where it comes from.
The minimum contribution into an auto-enrolment-compliant workplace pension scheme is 8 per cent of salary, but many employers pay more.
Where the minimum is paid, for each £1 saved, another £1 is added for free. This is the key attraction of saving in a pension.
The 8 per cent minimum contribution is made up of 5 per cent from the employee and 3 per cent from the employer, it can be illustrated as being:
- 4 per cent self;
- 1 per cent tax relief; and
- 3 per cent employer.
To illustrate this, we consider the initial value given up through opting out by three different employees:
Table 1: Value forfeited and experience in an increase in takehome pay
| | John | Paul | George |
| Age | 30 | 40 | 50 |
| Salary (annual) | £15,000 | £30,000 | £60,000 |
| Annual contributions: |
| 4% personal contribution | £600 | £1,200 | £2,400 |
| 1% tax relief | £150 | £300 | £600 |
| 3% employer contribution | £450 | £900 | £1,800 |
| 8% total contribution | £1,200 | £2,400 | £4,800 |
| |
Anticipated increase in take-home pay | £1,200 | £2,400 | £4,800 |
| Actual increase in take-home pay | £600 | £1,200 | £2,400 |
| Costs realised | £600 | £1,200 | £2,400 |
| Source: Defaqto September 2023 |
Opting-out results in each employee losing their tax relief (it now becomes payable in income tax) and the employer's contribution stops. In other words, the £1 for £1 matching ceases.
George, as a higher rate taxpayer, has also been claiming additional tax relief of 20 per cent. This option ceases and therefore a further £600 is given up through opting out.
Planning consideration: universal credit
For those in receipt of universal credit (John) the cost of opting out could be much higher.
