When you exceed the annual allowance through accrual in a final salary scheme, there is the option of ‘scheme pays’ where part of the pension is commuted for a lump sum used to pay the scheme charge.

A deduction is usually made in the year in question and the final salary benefits are permanently reduced from this point. This is usually the end of it. The NHS pension system operates slightly differently in that the payment of a ‘scheme pays’ lump sum is a loan that is recouped when the member eventually takes benefits.

The ‘loan’ attracts interest of 2.80% plus the rate of Consumer Price Index (CPI) inflation so can easily end up exceeding 5% per annum.

It is therefore worth considering whether the default option of reverting to scheme pays stacks up for NHS members.

In 2016/17, the NHS paid out £35 million worth of ‘scheme pays’ lump sums across 3,949 member requests. This year however was prior to the change in rules that allowed scheme pays to be for members subject to the tapered annual allowance. It is therefore reasonable to expect the number to be higher going forward.

Case Study

For simplicity, we will assume we have a 55-year-old individual earning £113,000 per annum. They are a member of 1995 and 2015 section and so have accrual in both schemes. For the 2017/18 tax year their accrual was as follows:

1995 Section: £24,000

2015 Section: £53,000

Total:               £77,000

We will assume that no carry forward is available.

As is becoming increasingly common in the NHS scheme is the impact of a tapered annual allowance. The Threshold Income is above £110,000 and that means we need to calculate the Adjusted Income.

£113,000 per annum earnings + £77,000 ‘employer contributions’ = £190,000

£23,000 of contributions are personal and these can be subtracted

£190,000 – £23,000 – £150,000 = £17,000 excess

At a rate of £1 for every £2 exceeding, £8,500 of annual allowance is lost

The allowance for 2017/18 is therefore £32,500.

We therefore have an excess of £44,500

Based on earnings for the year, the excess would be taxable as follows:

£37,000 at higher rate tax: £14,800

£6,500 at additional rate tax: £2,925

Total: £17,725 (ouch!)

Note: If this individual’s earnings had been below £110,000, they would have escaped any tapering of the annual allowance. This would have resulted in the contribution amount being £37,000 above the £40,000 standard annual allowance which would have resulted in a tax charge of £14,800.

There has been recent press articles about the effective tax rate of over 100% on earnings that tip individuals over £110,000. This is through a combination of the Personal Allowance 60% tax trap and the fact that, in this example, earnings of £3,000 can create additional tax implications of £3,725 (above the income tax and NI the extra £3,000 is already subject to).

‘Scheme Pays’

Assuming the client does not want to pay £17,725 personally, they would elect for ‘Scheme Pays’ and have the NHS pay the whole amount.

The charge is apportioned between the two schemes so represents a tax charge of:

£5,524.67 (1995 Section)

£12,200.33 (2015 Section)

As mentioned earlier, the £17,725 charge is considered as a loan from the NHS to the member. If we assume CPI inflation of 2.50% and no change to the interest figure of 2.80% (which has been the case since 2016), the increase would be 5.30% per annum.

In five years’ time, this charge has now increased to £22,947.12. Apportioned between the two schemes:

£7,152.35 (1995 Section)

£15,794.77 (2015 Section)

This is how much each section of the scheme owes the NHS. We can now commute the pension for these lump sums. The current factors for a 55-year-old are:

19.70:1 for the 1995 Section (normal retirement age of 60)

11.80:1 for the 2015 Section (normal retirement age of 67)

If we apply these commutation rates the reduction in benefits would be:

£363.06 per annum (1995 section)

£1,338.54 per annum (2015 section)

Total: £1,701.60 per annum

Another way of looking at this is that by paying a lump sum of £17,725 to settle the tax charge, pension income of £1,701.60 per annum is retained in the scheme. This is effectively a ‘reverse’ annuity rate of nearly 10%.

There are a lot more variables to consider but here are how the personal circumstances of a client could influence the thinking:

Lifetime allowance position

  • If the client is currently close to breaching the allowance, seeing the scheme pension reduced by such an amount might be less of a disadvantage (as the 25% charge on excess will reduce a lot of a ‘gain’ of having paid the scheme pay charge up front.
  • Conversely, if LTA is unlikely to be breached, this could make paying the charge directly more attractive.

Potential tax position

  • If the marginal pension in question is likely to be taxed at higher rate tax, this reduces the attractiveness of maximising it at the expense of already taxed capital that would otherwise be used to make the scheme pays’ payment.
  • Even allowing for basic rate tax will reduce the relative value of the pension.

Length of time until access

  • The nature of 2.80% plus CPI makes the compounding nature of the loan a higher burden on the pension over a longer-time frame.
  • Shorter time frames are less likely to create as much distortion (although our example shows the effect over only five years).

Family planning

  • There is more scope for wealth planning across generations through cash deposits in the short-term, compared to a higher pension income in the long-term. For those with already secure and sufficient retirement income prospects the retaining of capital will probably be preferable.

Contributions being made

  • Contribution rates are a double-digit percentage for most earners over £50,000 and it can be worth considering how the value actually being contributed as a member of the scheme links with the possible lump sum tax charge and/or benefit that might be accrued.

Additional points to consider would be the source of the lump sum that could be used to pay the tax charge directly. If this is from post- higher rate tax income then it would feel like a double (and very high) tax charge.

It could be thought of as around £30,000 of income paying both £12,000 in income tax and £17,725 in pension annual allowance tax.

Summary

Compared to the options in private final salary schemes, the ‘scheme pays’ function of NHS members needs more thought and consideration. Short of leaving the scheme (which is almost never advisable) these members cannot really plan their way around a tax charge in the scheme.

There could however be scenarios where it makes sense to consider a direct payment of the tax charge incurred, or to have the scheme pay the charge. It may even be advisable to approach this in different ways in different years.

Recent press suggests that a number of individuals are already looking at their income position and actively turning down shifts over fear of the £110,000 threshold. This remains potentially the only major tax planning option in regards to pension accumulation in the scheme.

How we help

Annual allowance and tax charge calculations are something we offer as standalone research services. We can cover research and report writing on all aspects of pension contribution / annual allowance and carry forward services. Contact us at hello@para-sols.co.uk or 01325 281 969 if you would like further information.

With recent changes to FOS requirements and the impact to professional indemnity insurance providers, the CII provided a timely event in Leeds this week to address the complaint concerns from the side of a solicitor firm handling the disputes. The meeting was held by Mills & Reeve LLP, who are professional indemnity insurance and commercial disputes litigators.

It was clear to them (and anyone in financial services), that the IFAs are now more accountable as pension freedom, client’s access to DIY research, greater capital reserves and a client’s desire to make money work harder, has created a greater interest for investments. With the knowledge that consumers have the free protection of FOS and the Claims Management Companies (CMCs) supporting a no win no fee culture, the advisers are facing a ‘perfect storm’ on the advice they give.

Undoubtedly, the effects of this storm may not yet be seen – Warren Buffet famously said “only when the tide goes out do you discover who’s been swimming naked” and therefore the opportunity to look for potential poor advice will come into focus when the next market fall occurs.

The focus of the remaining part of the meeting was to highlight the concern of a litigator when they are dealing with claims.  They stated that the reports they see have 2 elements that FOS will look upon, the suitability of the advice, and the suitability of the product.

 ‘You should never have advised the client to …’

They stated that the claims for suitability of advice would fall foul when the lack of alternative options was not discussed or evidenced. They found that the lack of benefits to say why the transfer or switch was in the client’s best interest was also a common theme.

‘You failed to warn the client of the risky nature of …’

The complaints were upheld when a failure to assess the client’s attitude to risk was completed correctly, and/or a lack of sufficient experience was established. In some cases, reports lacked detailed risk warnings to validate the recommendation.

Access to FOS

The explanation on how they feel FOS approach disputes was a topic that grabbed the attention of the room.

They stated that FOS has ‘wide discretion’ and will generally take customer-focused fairness towards its outcomes. Although FOS must adhere to the rules and regulations, they are not bound by the law when they feel the outcome is fair and reasonable for the client. Therefore, this will undoubtedly create some inconsistent decisions.

One of the rules that Mills & Reeve commented on was the 6-year time limit for complaints – they stated that this was something that was not a fixed rule and they often saw cases that exceed this term.

Insistent clients

The complaint involving insistent clients was one of the topics that were often seen on the litigator’s desk. This was mainly due to the process of (or lack of) a good understanding of the insistent client rules. They commented that it was not enough to simply rely on a standard insistent client form for the client to accept responsibility, as this was not sufficient to evidence that the client understood the consequences.

They commented on the FCA requirements to have a hand-written client letter or taped discussion (with agreement), to confirm the client’s understanding of the firm’s original recommendation not to proceed and their own statement confirming their understanding of the recommendation and their acceptance of consequences when rejecting the advice. They feel that this was often the best way to avoid any poor outcome.

Mills & Reeve summarised their top tips to help avoid potential complaints being escalated:

  • Ensure your meeting notes are documented clearly (this is also a MiFID requirement).
  • Don’t advise on areas that you are not familiar with.
  • Don’t be complaisant with long-standing clients or become too close.
  • Review files with peers for second checks.
  • Keep up to date with new developments (check COBS rules).

Ensure you have adequate PI cover

The recent PI changes, following FOS updates on the 1st April, has made many firms look at their own PI cover. Mills & Reeve stated that it is important to know what is, and what is not, covered by your PI insurance.

The current market conditions have led to a price-conscious approach to PI but it is important to know now what you fully protected for, in the event of a claim. It is important to know what exclusions are in your PI cover and if this will impact on your firm’s investment proposition.

In conclusion, if you operate a ‘whiter than white’ approach to everything stated above then you can sleep easy in your beds tonight, for those who may have some grey areas in their standards, it is a good time to review your processes and tighten up on areas that may leave you potentially exposed to future complaints. For those who live in the dark side, hold on for a bumpy ride!