The “butterfly effect” is a concept that describes how seemingly small actions can have significant consequences later.
Ray Bradbury introduced the idea in his short story A Sound of Thunder, in which a time traveller alters the course of history by accidentally stepping on a butterfly.
Yet, it was meteorologist Edward Lorenz who officially coined the term when he theorised that the flap of a butterfly’s wings might trigger a series of events that eventually results in a tornado halfway around the globe.
The decisions you make about retirement saving are unlikely to change the course of history or create a tornado. However, choices you make now could influence the size of your pension pot and your quality of life in the future.
Indeed, the Institute and Faculty of Actuaries (IoFA) conducted research into pension saving and identified several choices that could make it more difficult to reach your retirement goals.
Read on to learn about three pension decisions that could reduce your retirement pot by £100,000 or more.
1. Not contributing to a pension early enough
You may not have considered planning for retirement when you were in your 20s and 30s because it seemed so distant. Yet, one of the advantages of starting early is that you benefit from the compounding effect for longer. Compounding is when you generate returns on previous growth as well as your original investment.
For instance, if you invested £1,000 and saw a 6% return, you would have £1,060 the following year – your £1,000 initial investment plus £60 growth.
If you left that wealth invested and generated another 6%, you would see returns on the full £1,060. This means you’d see growth of £63.60 in the second year, giving you a total of £1,123.60.
Over time, this compounding effect can help you grow your wealth much faster.
That’s why research shows waiting until later in life to start your pension could significantly reduce the size of your retirement pot. This is because you don’t contribute as much and, more importantly, you don’t benefit from compounding for as long.
For example, the IoFA report shows that if you had a salary of £28,000 at age 25, and made a 10% pension contribution annually, by the age of 65 you would have a pension pot of around £800,000.
This assumes that your salary increases by 4% each year and pension contributions rise in line with your income. It also assumes investment returns of 6% a year.
Conversely, if you waited until you were 35 before you started contributing to your pension, you would only have £500,000 in your retirement pot at 65. This is a difference of £300,000.
So, no matter what age you are, you may want to start saving in your pension right away if you haven’t already. It could also be beneficial to encourage your adult children to consider retirement planning as soon as possible.
2. Opting out of your pension
The cost of living crisis may have put pressure on your finances over the past few years, and you wouldn’t be alone. Unfortunately, some savers decided to opt out of their pensions to increase their take-home pay and cover rising expenses.
According to Sky News, the total number of financially vulnerable individuals in their 30s who are not saving in a pension increased to 1.43 million in the past year.
While this decision to opt out of pension contributions may help savers manage their short-term expenses, it could have a significant effect on their quality of life in retirement.
That’s because the IoFA report found that opting out of your pension between 35 and 40 could leave you £206,000 worse off in retirement. These figures are based on the same assumptions as the previous example.
A break in contributions later in life may not have as much of an effect but the study shows that pausing contributions between 55 and 60 could still reduce your pot by around £100,000.
As such, if you’re concerned about the cost of living, you may want to look for other areas of your budget to cut back on rather than opting out of your pension.
3. Failing to take advantage of employer contributions
One of the benefits of paying into a pension is that your employer may contribute too. Auto-enrolment rules specify that if you meet the minimum earning requirements, you must contribute at least 5% of your salary while your employer pays in 3%.
However, you are free to increase your contribution if you want to build your retirement savings faster. In some cases, your employer might match your contribution if you increase it.
Even a small change could have a marked effect on your retirement pot in later life. For example, the IoFA reports that a 1% increase in contributions from your salary over the space of 40 years could give you an additional £100,000 in your pension pot.
This is because you may benefit from additional employer contributions and could also receive tax relief on the extra payments.
As such, you may want to check with your employer whether they’re willing to match your contributions if you increase them. Doing this as early as possible may allow you to build a larger retirement savings pot.
The choices that you make about your pensions now may dictate the quality of life you have in retirement, so it’s important to think carefully before making any decisions.
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Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of investments and any income from them can fall as well as rise and you may not get back the original amount invested.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.
Workplace pensions are regulated by The Pension Regulator.
HM Revenue and Customs’ practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen.
Approved by the Openwork Partnership on 03/10/2024