Pensions for the self-employed? Sometimes an ISA can be nicer

The ONS published a report this week showing that the proportion of self-employed men contributing to a personal pension has fallen sharply over the past 20 years. Just over 60 per cent were adding to a personal pension in 1996/7, but today the figure is only 22 per cent (see the graph below). For some reason the ONS didn’t include the details about self-employed women, but our own analysis of government data shows the picture for them is more or less the same, with around 25 per cent actively contributing to a pension.

Our data crunching also reveals that the self-employed are likely to have smaller pension pots than employees. The average total pension wealth of the age group closest to retirement (55-64 year olds) is £50,000 for the self-employed, versus £104,000 for employees – in other words, less than half the size. Moreover, around 23 per cent of the self-employed in this age group have no pension wealth whatsoever, compared with 17 per cent of typical workers.

There are a number of reasons for this phenomenon. The first is simply that people who work for themselves tend to have lower incomes. The full-time self-employed now earn approximately 20 per cent less than their employee counterparts, meaning they have less disposable cash to drop into a pension. The second explanation is that they do not enjoy the considerable employer contributions that wage workers benefit from. The insurance firm Prudential estimates that the loss of employer contributions for an average self-employed person amounts to as much as £91,500 over a lifetime.

The third reason – at least for why their final pension pots are smaller – is that the self-employed appear to start contributing to a pension much later in life (see the graph below). This is a significant but often overlooked trend. For example, someone saving £100 a month for 40 working years would end up adding the same amount to their pension as someone saving £200 a month. Yet as the Money Advice Service points out, the nature of interest accrual means that the early starter would end up with a much larger retirement fund. With a 6 per cent interest rate, the person saving for 40 years would have a final pot of £190,000, whereas the person saving for 20 years would have only £90,000 – an enormous difference.

Yet there is an even more important factor: the self-employed are deserting pension schemes for ISAs. This is because ISAs are more flexible, allowing the self-employed to draw out cash to tide their business over in times of unexpected difficulty. Compare this to the money tied up pensions, which can't usually be touched until people are well into their 50s. Most ISAs also allow people to pay in variable amounts as and when they like, meaning they can change their level of contributions depending on how much money they're making.

The popularity of ISAs may help to explain why the self-employed report having greater financial wealth than employees. According to our analysis, self-employed-only households have approximately three times the amount of financial wealth as employee-only households. Some commentators even believe that ISAs should be treated as the main repository for retirement savings among people who work for themselves. Michael Johnson from the Centre for Policy Studies argues that pensions are designed for a by-gone era when income was stable and people worked for a handful of employers. In a world where self-employment is commonplace and earnings are volatile, flexible ISAs are often the better of the two savings options.

Needless to say, we should take all of this with a pinch of salt. The self-employed should of course aim to save for a pension, not least because the rate of return is usually better. Yet we do need to acknowledge that pensions are only one part of the savings equation. If we really want to increase savings rates among the self-employed then we should start by improving the quality and accessibility of ISAs, and building awareness of them among a broader swathe of the population. In practice this could mean automatically enrolling business owners onto an ISA when they register with HMRC (contributions could be tied to profit levels), or adding a degree of tax relief to the money paid into such schemes (as is the case with pensions).

In any case, we should be wary of claiming that the self-employed face a ‘time bomb’ or a ‘pensions nightmare’. For some, it seems, an ISA is much nicer.