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.
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
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).
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).
- 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.
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.
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