The cost of missing a year's pension contributions, or starting one year late, is far greater than you think, but is it worth protecting your payments?
Isn't personal finance a complete minefield? Earlier this year, I read through a pension contract for a friend and found the dreaded word 'protection'. I immediately thought of payment protection insurance (PPI), which The Fool has criticised for years as hugely over-priced, from most providers anyway. This protection exists for a variety of products, including:
- Mortgages: mortgage payment protection insurance (MPPI)
- Credit cards: credit card repayment protection (CCRP)
- Personal loans: personal loan protection (PLP)
Anyway, I was right: it was another PPI policy. I must admit, I'm less familiar with 'pension contributions protection' (PCP), but nevertheless alarm bells rang. I advised my friend not to take up the protection with his pension provider without comparing costs with other providers first. I also recommended he considered the benefits of an income protection policy as an alternative.
Then, I thought, what if he decides not to get any kind of insurance for his pension contributions, or what if he delays signing up because he procrastinates (for yet another year!) over finding alternative protection?
I ran a simple test.
Scenario one: let's say he has 40 years until retirement. (I'm being kind.) In the first scenario, he thanks me enthusiastically for my guidance, digs around for any protection he requires and signs up to his pension plan within one month. He contributes £200 every month for the rest of his working life, which is £256.40 per month after tax relief.
40 years later, his pension fund has grown, let's say, 8% per year after charges. His pension pot has reached £831,000 after contributing £96,000 in total.
Scenario two: he dithers for a year before contributing £200 every month (£256.40 after tax relief) for the rest of his working life. 39 years later, at a rate of 8% per year his pension pot has grown to £767,000. He has contributed £93,600, just £2,400 less than he did in scenario one, and yet his pension pot is smaller by a massive £64,000!
Scenario three: he starts contributing straight away, but he doesn't get protection for his pension contributions. He's out of work through accident for a year in the fifth year of his pension. His pension pot at the end is £785,000. Although he has contributed the same amount as he did in scenario two, £93,600, his pension pot is greater by £18,000, because he has benefited from compound interest for longer. However, it is still £46,000 less than he got in scenario one.
I think the lessons we learn here are obvious. Firstly, it really rams home how important it is to start saving earlier rather than later. Secondly, if you are concerned about accident, sickness or unemployment, you should consider some sort of insurance. Just make sure it's not a rip-off.
More: The Big Idea In Pensions
> Take a look at income protection insurance through The Fool.