Why the increase to workplace pension contributions is a much bigger deal than you think
To some this will seem just another of those irritating little deductions that come through on salary slips, but in reality the amount you contribute will have a huge impact on your future
From Saturday, the start of the new financial year, the 10 million or so Britons who are included under the pensions auto-enrolment legislation will have their workplace pension contributions go up from 5 per cent of their salary to 8 per cent.
Employees have to contribute 4 per cent and employers must add at least another 3 per cent, with a 1 per cent top-up from the government. That is the minimum. For many people the contributions will be higher.
To some this will seem just another of those irritating little deductions that come through on salary slips, along with tax, national insurance, student loans and so on. Actually it is huge, as big in its social and economic implications as the surge in home ownership that took place in the UK from the 1950s onwards.
The reason for the government’s drive behind this is simple. It is mathematics. Given the ageing of the population, a common theme across the developed world, the state will not have the funds available in 20 or 30 years’ time to pay adequate state pensions. So the more people who can supplement the state pension with a funded occupational pension, the less the burden on the next generations of taxpayers.
It is a rare example of a government taking a decision that will not affect voters, or at least not much, in the lifetime of the current parliament, but will transform the situation a generation ahead.
But we should not, I suggest, see this in terms of the government reducing the tax bill for working people in 30 years’ time, though it will have that effect. Rather I think we should see it from the ordinary person’s point of view, in that it creates another path, alongside home ownership, that will enable people on average earnings to build up wealth.
At the moment the main way people build wealth is through their homes. Owner-occupation has been falling in recent years. It reached a peak of 70 per cent of homes being owned by their occupants in 2002, but for various reasons including the unaffordability of housing, it has tailed off. But it is still 63 per cent of housing stock, and seems to be rising again. For most people their home is their main asset.
One of the reasons why the median wealth of a UK family is more than £260,000 is the value of their home. But it is a form of wealth that has obvious drawbacks, in particular that it is illiquid.
People who need to increase their income can do so by releasing some of the equity they own in the house by borrowing against it. But many people have come to grief by borrowing too much, and finding themselves homeless as a result.
Building a pension pot is a parallel path to wealth. It has other limitations – your money is locked up – but also the great advantage that compound interest will make it grow.
As we reported, a 30-year-old on average earnings, and paying £27 a week into a pension, could expect to accumulate a pot of £125,000 by the time they retired. (My own calculations suggest a somewhat higher figure, but this all depends on the assumptions you make.)
The central point here is that money paid into a pension is your money, and does not disappear to the great black hole of general taxation, unlike so-called national insurance, which is not insurance at all but simply a payroll tax.
This leads to a final point. As Merryn Somerset Webb, editor-in-chief of MoneyWeek, writes, long-term returns for shares in the US have averaged 6.4 per cent in real terms for the past 119 years.
In the UK they have been 4.2 per cent. For a period that covers two world wars, the great depression of the 1930s, and the great inflation of the 1970s and 1980s, those are astounding returns.
I think it is reasonable to assume that shares will return around 5 per cent over the next 50 years, the appropriate time horizon for someone starting work now. Auto-enrolment enables people to start on that path to reasonable wealth. Simple as that.