Updated 19 May 2022
One in two freelancers are now actively paying into a pension scheme, a new study has found. But despite this greater uptake, over two million self-employed people face serious questions over how they will fund their retirement. Article by Nick Green.
The number of contractors and freelancers saving into a pension has passed 50 per cent for the first time, according to a recent survey. Last year an estimated 600,000 more self-employed people took out pension schemes for the first time, in a dramatic increase on 2018 when just 36 per cent were building pension pots. However, freelancers still lag considerably behind employees, around 80 per cent of whom are active pension scheme members.
The survey, by SJD Accountancy, shows a significant move by the freelance sector in favour of pension saving. This is likely a beneficial side-effect of auto-enrolment, which means that employees automatically join workplace pension schemes unless they opt out. Though contractors are not eligible for auto-enrolment, it seems to have alerted them to the value of pensions as a tax-efficient savings vehicle, and to the importance of long-term saving for retirement.
Another key finding of the study was that more than six in 10 self-employed people expect to working at age 65 or over. This may be either a pessimistic or an optimistic prediction, but it highlights the fact that only a minority expect to have saved enough to retire at that age.
Pension saving appears to be a growing trend among self-employed people, with much of the impetus coming from the younger generations. Of the 50.2 per cent of self-employed workers making pension contributions, 60 per cent were under the age of 30 when they started to save for retirement. The remainder (40 per cent) had reached ages of 31 or over before setting up their pension pots. Though now much better prepared for retirement, this substantial group has missed out on at least 10 years of tax relief and tax-free growth, by not starting their pensions earlier.
Even more concerning, however, are the nearly 50 per cent of self-employed people who are not actively saving into pensions at all. Some may have alternative plans in place for funding their retirements, but others may be delaying setting up a pension to some unspecified future time – or simply in a state of denial.
There are a number of reasons why freelancers and contractors may be slower to start a pension. Being self-employed often means your income is irregular and hard to predict, so you may prefer to keep ready cash reserves rather than put money away into a pension.
Secondly, self-employed people may feel less pressure to have retirement savings, believing that they can simply continue to work into old age. However, the most common reason for neglecting pension saving is simply the lack of external pressure to do so. Even before auto-enrolment, employees were often invited to join the workplace pension scheme, but there is no such prompting for contractors. Consequently, starting a pension is a task that many self-employed people put off indefinitely.
But contractors who neglect their pensions are missing out on huge tax-saving opportunities, as well as running the risk that they will have insufficient income in old age. Pensions remain the single most tax-efficient vehicle for long-term saving, and contractors who understand how they work can use them to great advantage.
As a self-employed person you have two main options for your pension. One is simply to open a personal pension, such as a stakeholder pension or a SIPP. You can pay into this pensions regularly (e.g. on a monthly basis) and can take contributions breaks if you need to.
The other way is to set up your own ‘workplace pension’, which you can do if you operate as a limited company. As soon as you set up your company, you’ll be considered an employer (even though you may be the only employee), so would normally have to take part in auto-enrolment. However, you can apply to the Pensions Regulator for an exemption if you’re the only director/employee.
Once you’re exempt from auto-enrolment, you can set up a company director pension for yourself.
A company director pension is similar to a standard workplace pension, except of course that as director you have more control over how much the company pays in directly.
There are two ways to contribute to your director’s pension: as an individual (out of your income or savings), and via the company. Contributions made from your personal finances are called employee contributions, while contributions made directly from company finances are called employer contributions.
When you make employee contributions, you can pay in up to a maximum of £40,000 a year or your ‘total earned income’. Total earned income includes salary but not dividends. Therefore, if you’re taking a combination of salary and dividends, your salary may be quite low, limiting how much you can pay into your pension.
A better option may therefore be to make higher employer contributions. These are not limited by your salary, and can in theory be up to £40,000 per year. These company contributions are also an allowable expense against corporation tax. Note that the total of employee plus employer contributions can never exceed £40,000 (your annual allowance).
Making contributions into your director’s pension straight from the company offers yet another way to save tax. There’s no National Insurance payable on pension contributions (unlike on salary), so you (via your company) can save up to 13.8 per cent. In total, paying money from your company directly into your pension can save nearly 33 per cent when compared to paying yourself a salary.
Pension contributions from the company are also considerably more tax efficient than paying dividends. Dividends are paid out of profits after corporation tax, and then you have to pay dividend tax. By contrast, company pension contributions come out of pre-tax profits, so for a higher-rate taxpayer this is equivalent to tax relief of over 45 per cent.
Updates to the IR35 legislation in 2020 will put more pressure on businesses to decide whether contractors are in fact employees in all but name. In the case of long-term contracts in particular, some companies may choose to end the uncertainty by changing contractor roles to employee roles, perhaps on a fixed-term employment contract. Although there are drawbacks to being hired as an employee (such as lower face value wages), there are also significant advantages. One of the biggest benefits is automatic enrolment into the workplace pension scheme, which includes employer contributions to that pension.
If you find yourself compelled to take a lot of fixed-term employment contracts due to the IR35 changes, you can avoid having to start a new pension scheme every time you change employers by maintaining your own stakeholder pension. You can then ask each employer to pay all contributions into this pension.
The value of saving up a nest egg for retirement is clear. However, contractors who don’t use pensions are effectively paying far more of their profits to the tax man than they need to. Missing out on pensions means missing out on up to £40,000 of tax-free saving every year, as well as the valuable year-on-year growth of a pension pot. Even if retirement is only a few years away, self-employed people can still take full advantage of these benefits.
Find out more about setting up your own pension by contacting a financial adviser.