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Personal Finance

Why you should not withdraw pension savings prematurely

retire
The golden rule of realising value out of your retirement savings is to save consistently from all your incomes. FILE PHOTO | NMG 

The aim of having a pension plan is to afford consistent income in retirement; however, there are occasions when a contributor can access all or a portion of their money before retirement.

The most common types of early withdrawals occur when retirement fund members change jobs or resign and they need some kind of money to stay afloat.

Research shows that people typically move jobs between five to seven times throughout their career life, and one of the biggest retirement mistakes one can make is to cash out pension fund whenever one changes jobs.

The option to cash out one’s pension is a big temptation which many people cannot resist and it is a matter of great concern. People will give all kinds of explanations for cashing out, from “I have to pay off my debts,” or “I am okay paying the tax, “I will make up for it later,” or “I’ll get another investment with better returns than my pension fund.” Then upon reaching retirement, with barely enough money, not preserving the capital becomes one of their biggest regrets.

Many members exercise the option of taking their money without fully understanding the devastating impact “premature withdrawals” will have on their long-term pension plan and their future.

While this may seem like a quick cash-flow remedy, cashing out your pension not only borrows from your future for early gratification but is also in actual fact an act of self-sabotage of your financial position in retirement.

Pension consultants at Enwealth Financial Services observe that many retirement fund members are unaware of the severity of having to pay hefty penalties and tax. Although the penalties for early withdrawals vary depending on the service provider, legislative taxes still apply.

According to a tax report released by Deloitte and the Kenya Revenue Authority, all early withdrawals are subject to normal Pay-as-You-Earn. Constant withdrawals out of your pension fund and relatively low contributions will significantly result in paying more tax for each withdrawal, leaving you with less and less money to retire on.

Taxes aside, premature withdrawal from a retirement plan can cause the fund member to lose on compound interest. When you withdraw early, you not only lose your savings but also you miss out on the accumulative interest you would have earned over time.

This is referred to as opportunity cost, a popular term used by investors where one misses out on compounding interest over time.

To put this into perspective, imagine you started working at 25 years of age and started your long-term savings towards retirement at the start of your working life. Assuming you save Sh1,000 per month over your entire working life without “breaking into the vault” for 25 years until age 50, your savings would grow to Sh1,233, 324.90 based on an average annual net return of nine per cent. However, if after 10 years you choose to change jobs, cash out your retirement to, for example, upgrade your phone, car and to start saving afresh at your new company, the consequence is that when you retire you would have saved only Sh398,000, that is 68 per cent less to retire on.

The golden rule of realising value out of your retirement savings is to save consistently from all your incomes and preserve your benefits to realise the benefits of compound interest over time.

Cashing out your money during the journey is tempting but will invariably not be worth it in the long run. It is also wise to utilise pension funds as a vehicle to effectively diversify your investment and manage your tax liabilities and lastly not to forget that the objective behind savings is to attain financial security and freedom in retirement.

Nelson Kuria, Chairman, Enwealth Financial Services Ltd.

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