There is much to consider when looking at self-employed pension options, but you will hear little of the risks of not contributing to your pension. In the current challenging economic environment, it is essential to appreciate the pros and cons and the long-term impact on your retirement income. Unfortunately, many businesses are struggling, looking to cut costs, and while pension contributions may seem an easy target, the financial consequences can be severe.
Challenges facing the self-employed
Earlier this year, the London School of Economics and Political Science issued an in-depth report into the self-employment market, containing some sobering statistics. The report showed that:-
- Self-employed pensions are, on average, 56% less than employees
- 73% of the self-employed weren’t contributing to a private pension
- Nearly one in four were unsure they would be trading at the year-end
The main reasons given for not contributing to a private pension were as follows:-
- Lack of liquidity
- Reliance on other income
- State pension income
- Lack of knowledge/trust
The survey also covered potential interest in a hypothetical self-employed pension scheme backed by the government.
If the government were to match self-employed contributions of 5% into a pension scheme, 33% of those earning less than £10,000 would participate. The figure increases to almost 50% for those earning over £10,000 a year. Unlikely to happen and potentially expensive for the government, this gives a compelling insight into the self-employed sector.
Self-employed pension options: Contributions
There are numerous factors to consider concerning self-employed pension options and contributions, some of which may be obvious while others less so.
Can you afford to give up pension tax relief?
If you decide not to contribute to your pension scheme, you will not receive any tax relief from the government. At the moment, you are eligible for tax relief on contributions on the lower of:-
- 100% of your income
- £60,000 per annum
In isolation, as a basic rate taxpayer, for every £100 you contribute to your pension scheme, you will receive a further £25 from the government. The figure increases to £50 for a higher rate taxpayer and £56.25 for an additional rate taxpayer. For example, if you were to contribute £10,000 to your private pension, this would increase to £12,500 with basic rate tax relief.
The impact of compound growth
If you decide to suspend contributions into your self-employed pension for just a couple of years, using a ballpark net figure of £10,000 per annum, your pension fund would be a gross £25,000 lighter. This situation is exacerbated when considering long-term compound capital growth of up to 40 years and above before retirement.
We will assume 3% annual growth over a 40-year period to demonstrate the potential loss of compound capital growth. In this scenario, the initial £25,000 would be worth £81,550, which equates to a gain of £56,550. Obviously, on greater contributions for an extended period, the impact could decimate your income in retirement.
State pension may not be enough
The current maximum state pension is £203.85 a week, which equates to just over £10,600 per annum. This compares to the average gross weekly earnings in the UK (as of June 2023) of £613, or £31,876 per annum. This equates to an average take-home pay (after tax but excluding pension contributions) of £25,782. As you can see, there is a significant financial risk to self-employed people, even those earning the average wage and expecting to live off the state pension.
You might need to work longer
We all work longer due to the increased state pension age, higher cost of living and reduced savings/investments. A recent survey showed that last year, there were 446,601 people above 70 years of age still working, a 61% increase on the 277,926 figure for 2012. This trend has been replicated across the entire employment market, with reduced pension assets for the self-employed likely to extend their working life even further.
Having potentially worked upwards of 40 years, when do you get to enjoy your retirement?
Dependence on savings
In a perfect world, a combination of private and state pension income and possibly part-time employment would be enough to cover monthly outgoings and leave sufficient to enjoy later life. More and more people depend on their savings to cover everyday expenses, putting massive pressure on long-term finances. When considering the tax relief on pension contributions, an immediate minimum 20% enhancement, it may be sensible to consider switching an element of savings into your pension fund.
Either way, it would take significant savings to fund your life in retirement, aside from the potential tax benefits of pension contributions.
Should you downsize your house?
In the long term, we have seen a significant rise in the value of homes across the UK. For most people, their home is their most valuable and certainly their most important asset. Failing to plan for retirement, predominantly lacking pension contributions, has forced many people to downsize their homes. Once seen as an inheritance, your legacy for the children is sold to provide vital income to fund everyday living expenses.
Other options, such as equity release and home reversion schemes, can create long-term income streams. However, this can significantly impact your estate and reduce the ability to leave assets to your children and other beneficiaries.
It might be difficult to sell your business
As a self-employed individual, you may have built a significant business over the years, often focused on a mutually trusting long-term relationship with your clients. In effect, you are the business; you were probably the reason why many people have retained your services over the years, and you are the most valuable asset. While there will be a healthy demand for any successful self-employed business, client loyalty can be tested when a new party takes over.
If you have a successful business, it is understandable why you might assume this is your best asset, your quasi-pension and a means to create strong income streams in the future. In reality, there is often enhanced risk associated with the sale of a business focused on retiring individuals. This can be reflected in the price, which could be significantly less than your assumed market value. As a consequence, there could be unexpected funding difficulties in retirement.
Reduced financial protection for your family
Aside from a well-funded private pension providing long-term income for you and your family, it can also act as a financial safety net on your death. There are potentially significant inheritance tax benefits associated with pension funds, which are typically transferred to beneficiaries free of tax (generally outside of your estate) on your death. Income tax liabilities will vary whether you die before 75, typically no additional taxation, or after 75, usually your beneficiaries pay income tax on withdrawals.
Long-term financial planning
Similarly to many households reconsidering the value of insurance premiums in challenging times, it is natural for the self-employed to review pension contributions on reduced income. The reality is that tax relief afforded to pension contributions, whether at the basic rate of 20% or higher, immediately uplifts your funds. This is before the potential for attractive long-term compound capital appreciation, which can be significant going forward.
One of the unspoken difficulties of suspending pension contributions in the “short term” is the likelihood that you will adapt your budget. Consequently, you may be reluctant to redirect funds back towards your pension in the future. The cost of living crisis has created an environment where many households, self-employed and employees, struggle to cover living costs, never mind discretionary spending.
You must take long-term financial advice and review your situation regularly. While often difficult to focus on the long-term when faced with potentially substantial short-term financial challenges; remember, all long-term financial plans are flexible. Nothing is ever set in stone!
Catching up with pension contributions
If you are struggling to fund short-term pension contributions, assuming that your finances improve in the future, looking forward, you can backdate payments over the previous three tax years. This allows you to utilise unused elements of your allowance, benefiting from tax relief and increasing your pension assets.
The impact of inflation
Inflation is having a considerable impact on relative spending power, and while thankfully down from double digits just a few months ago, inflation is still uncomfortably high. When your financial situation improves and you can recommence pension contributions, you should consider increasing annual contributions in line with inflation. In theory, placing possible investment returns to one side, this should at least maintain your spending power in the future.
Summary
There are many obvious, and some not so obvious, risks for those considering suspending or reducing their pension fund contributions.
As well as the immediate financial consequences, there can be a knock-on effect on your personal assets, protection for your family and other long-term income streams. However, in the current environment, it is perfectly understandable that many employed and self-employed people are looking for cost savings, ways to reduce their budget and keep their heads above water.
The consequences are potentially more severe for those with a self-employed status due to a lack of additional employer pension contributions. There’s also the fact that typically, YOU will be the business, attracting and maintaining long-term client loyalty, which can sometimes impact the potential sell-on value.
While there is much to consider concerning self-employed pension options, it is vital to take advice before making any changes, giving you time to consider the pros and cons. Our team of experts can guide you through the options; feel free to contact us at your convenience.
