In a few days, the landscape of pensions in this country will change forever. Seven million first-time savers will be automatically enrolled into a workplace scheme in a move designed to bolster their retirement income and alleviate the financial burden on the state. But if you've already got a big pension pot, watch out - you could be about to get your fingers seriously burnt.
Auto-enrolment is a huge and positive step forward for the financial future of our nation as a whole, but it has been designed with minimal consideration for wealthy savers. Horse-blinkered politicians have created a beast that could unleash a host of harmful consequences - with the nastiest surprises to be dished out to the ill-informed. Disappointing reductions in employer contributions to workplace savings, 'cautious' default funds stifling your investment returns, and horrifying six-figure tax bills are on the verge of becoming an unexpected reality.
Don't fall into sneaky traps
If you want to protect your hard-earned savings from damage you need to be on the ball over auto-enrolment. If you're one of the tens of thousands of people who took out enhanced protection for your pension fund to avoid exceeding the old lifetime pensions tax limit of £1.8m, or fixed protection against the new cap of £1.5m, listen closely (that means anyone in line to get an income of £75,000 or more from a final-salary pension). Because, as long as you're employed, staying opted in after you're auto-enrolled will completely void your protection.
Here's how. If you're earning £8,105 or more as an employee you will be automatically enrolled into a workplace pension scheme and given a one-month window to opt out. If you tell your employer you want to leave the scheme within this period, your protection will still be valid because HMRC will treat you as if you were never 'in' the scheme.
That's fine. But the problem occurs if you forget to do it in time. Opting out just one day after the deadline will cause you to lose your protection immediately. It means a pension contribution of just 1p will result in tax penalties ranging from tens of thousands to millions of pounds (see table below), depending on how big your pot is. And to make matters worse, this will happen every three years as employers have a duty to re-enrol staff that have opted out at three year intervals.
Extra tax payable if enhanced and fixed protection lost via auto-enrolment
| Current value of fund | Enhanced protection | Fixed protection |
| £1.6m | £25,000 | £25,000 |
| £1.7m | £50,000 | £50,000 |
| £1.8m | £75,000 | £75,000 |
| £2m | £125,000 | £75,000 |
| £3m | £375,000 | £75,000 |
| £5m | £875,000 | £75,000 |
| £10m | £2,125,000 | £75,000 |
Source: Standard Life
The industry has been sticking up for savers vulnerable to this trap, but its protest has fallen flat. Adrian Boulding, pensions strategy director at Legal & General, says the government has "no sympathy" for the wealthy savers, or "fat cats" as they are sometimes referred to. "We've tried to persuade HMRC to give leeway to people getting caught out by this situation but they won't listen," he said.
He also warned against getting lulled into a sense of security by financial advisers - as many will not be organised enough to locate and inform all their customers of the risks on time.
HMRC told Investors Chronicle: "We will be applying the law as it is stated, including time limits. Where exceptional and genuine circumstances are brought to our attention, we will consider the case on its own merits as we do in all our work areas."
You also need to stay alert if you're a high earner who's quit pensions in favour of other investments - or if you're having a break from saving. Around half of those earning over £100,000 (around the salary you need to be in danger of reaching the lifetime tax allowance) have stopped paying into pensions since 2008, so auto-enrolment could bring a nasty surprise in the form of a tax bill if the limit is accidentally exceeded. According to figures provided exclusively to Investors Chronicle by Standard Life, this could range from £25,000 to as much as £2.1m.
To be on the safe side, you should start keeping an eye on this when your pension pot reaches the £800,000-£900,000 mark, recommends Malcolm Small, head of pensions policy at the Institute of Directors. And you can also ask your employer for cash sums, called 'in-lieu-of-pension payments' to ensure you steer clear of the tax ceiling.
Another potential trap you need to be aware of if you want to safeguard your savings is the default fund your money will automatically be placed in if you stay opted in. There is currently more than £60bn of UK savers' money invested in default funds.
Defaults have been designed as 'safe' option to reduce volatility over the first few years of saving by investing in gilts and other low-risk asset classes. Analysts say this is "madness" because low risk equals low reward. The strategy also flies in the face of the riskier investments usually chosen for long-term investing. But the government is more worried about people who don't understand investment strategies (the vast majority) opting out if they see their investments go down. High opt-out rates would spell failure for the policy, so it's willing to deliver underwhelming returns for millions of savers because it sees it as a lesser of two evils.
As you can see from the chart below, the performance of the eight largest default funds ranges enormously. A fund below the line is an underperformer, above the line is an overperformer. The chart shows performance relative to the Association of British Insurers sector average after charges have been deducted
Performance of the biggest UK default funds
There are opportunities too
Although auto-enrolment comes with some nasty surprises, the good news is that you do have investment options and you can exercise them. You need to do some research into the default fund you are placed in and compare it with the other, potentially better-performing investment options open to you. If you do decide to ditch your default, John Lawson, head of pensions policy at Standard Life, advises picking a fund that fits with your overall appetite for risk. More experienced investors with high risk appetites might consider moving a chunk of workplace savings into a self-invested personal pension (Sipp), where you'll get access to a more exciting range of funds.
Not only is now the time for you to review your pension contributions and the way your money is invested to make sure you're generating the best retirement income you can - it's also a rare opportunity to exercise your influence over the pension you and your colleagues receive from your company. Businesses are being forced to review their pension offerings because of the new rules, so get your voice heard by the HR and pension managers within your company, by giving them your views on what a good pension scheme should look like; 95 per cent of FTSE 100 companies have no plans to cut staff benefits for auto-enrolment, and you could even stand a chance of getting a better deal put in place, from which you could ultimately benefit.
Auto enrolment safety checklist
■ You must opt out of your new pension scheme if you have enhanced or fixed protection or it will become void. The letter you receive notifying you about auto-enrolment won't notify you about this.
■ If you're a high earner and have stopped pension saving, check how much your pension investments can grow before you reach the tax ceiling.
■ If your employer contributes less to the new auto-enrolment pension than it did before, get the most out of your employer by upping contributions to your current scheme while you still can.
■ Don't assume a default fund will give you adequate returns to meet your needs.
■ You only have one month to opt out after your company's official auto-enrolment date.
