High-earning members of final salary pension schemes could be sleepwalking into tens of thousands of pounds in charges as a result of the Government’s tax reforms.
Last week, Money Marketing revealed that up to 100,000 public sector workers, primarily consultant doctors and dentists in the NHS pension scheme, could be better off opting out of their generous final salary arrangements.
This is mainly because staying in the scheme could result in higher tax costs than claiming fixed protection on the £1.8m lifetime allowance limit and leaving the scheme before April 2012 when the limit falls to £1.5m.
If an employee stays in the scheme, they cannot claim fixed protection. Those most likely to be affected are high-earners, those with long service and people whose pensions already exceed the 2012 lifetime allowance of £1.5m.
Standard Life head of pension policy John Lawson says the revelations present both an opportunity and a dilemma for advisers, who are likely to be nervous of the FSA’s reaction to recommendations to opt out of final salary schemes. He says advisers can sidestep accusations of misadvice by presenting a list of options to clients.
Lawson says: “It is a really difficult position for IFAs to be left in and they need to be very careful here. Advisers cannot recommend that a client should opt-out of a final-salary scheme because the FSA would probably jump up and down on them. Professional indemnity insurers would probably view it in a dim light as well.
“Years ago, we had the transfers and opt-out review and a lot of people were wrongly advised to opt out of the NHS pension schemes. There is a stigma against it and generally you would never tell people to opt out of a final-salary scheme, so my advice would be for IFAs to simply document the choices for clients without making a formal recommendation.”
Lawson cites the example of a 59- year-old male NHS doctor earning £160,000 a year, who has 37 years of service and pays the required 8.5 per cent member contribution for the NHS scheme.
Based on a pay rise of 3 per cent and inflation of 2 per cent between 2011 and 2012, the doctor will face an annual allowance tax charge of £960 on top of his £14,008 contribution.
On top of this, his lifetime allowance calculation will increase from £1,702,000 to almost £1,798,840 over the year.
If he leaves the scheme, he can claim fixed protection in 2011 but if he stays in the scheme he cannot and will be taxed at 55 per cent on the £298,840 above the new £1.5m limit.
If the doctor stays in the scheme, he will be taxed at 55 per cent on the £298,840, equalling £164,362. This means he will have to pay £179,330 in total, which includes his £14,008 contribution plus his annual allowance tax charge of £960, for an extra £4,200 of pension plus cash of £12,840. Lawson estimates the total value of this to be between £110,000 and £130,000.
Richard Jacobs IFA director Richard Jacobs says the problem is not confined to the public sector.
He says: “This is not just affecting the public sector, there are some private sector executives with final-salary benefits who will be hit by this as well.”
Jacobs says the complexity of the calculations used to determine the value of final-salary pensions means most high-earners will be unaware of the risks, or costs, of breaching the new annual and lifetime allowance limits.
He says: “If you look at the senior management in the NHS, local authorities and even head teachers, all these people have got to look very closely at what they have got and what they will be paying in tax.
“These are people who have been able to totally ignore not just pensions but also money issues. They have never had to think about money because they have had a job for life and a pension for life.
“They have got realise that there are some really serious tax charges here but people I have been talking to so far just do not believe it is going to happen.”
AWD Chase de Vere was hit with a £1.12m misselling fine by the FSA in November 2008 for “serious failings in its pension transfer business” after it advised clients to abandon their final-salary pension arrangements.
The IFA firm has since cut back its adviser numbers and refocused the business. The company now runs financial services for the British Medical Association, the professional medical association and trade union for doctors and medical students.
AWD Chase de Vere head of communications Patrick Connolly says there are “hundreds” of BMA clients who have potential issues with the pension lifetime allowance.
But Connolly admits that AWD would be nervous about advising someone to pull out of a public sector pension scheme.
He says: “We are seeing this already as a challenge in the private sector, so we are having to look at different ways to remunerate people who have large pension pots other than pension contributions.
“Public sector employees in this position face a seriously difficult choice of either opting out and accruing no further benefits or looking at the implications of a potential tax charge. Neither of those solutions is ideal but we would not be comfortable pulling anyone out of as final salary scheme full stop.”
The BMA itself has also raised concerns about the impact of the Government’s new tax rules. BMA pensions committee chairman Dr Andrew Dearden says the reforms represent a “threat” to NHS pensions.
He says: “Doctors are already facing major attacks from the Hutton review and Government plans to increase contributions.
These changes represent another threat because the increased tax bill will mean many doctors will question whether it is worth remaining in the NHS pension scheme.
“This is bad news for the scheme, which would be seriously destabilised if high-earners leave, increasing costs for lower-paid workers.”
Example provided by Standard Life head of pension policy John Lawson
Joe is a 59-year-old doctor in the NHS.
He earns £160,000 a year and has 37 years service. Like most doctors, he intends to continue working in the NHS after his 60th birthday.
The NHS scheme allows additional pension accrual up to 45 years, so he is a long way off that. He will get a pay rise of 3 per cent between 2011 and 2012 to £164,800 and inflation will be 2 per cent by the middle of next year.
Starting benefit is 37/80ths pension = £74,000, and 111/80ths cash = £222,000
Ending value is 38/80ths pension = £78,200, and 114/80ths cash = £234,840
Annual allowance calculation
Starting benefit = ((£74,000 x 16) + £222,000)) x 1.02 = £1,434,120 Ending benefit = £78,200 x 16 + £234,840 = £1,486,040
Increase over the year = £51,920.
He has exceeded the annual allowance by £1,920 and, on the basis that he has fully used his previous years, will pay a tax charge of £960.
This is in addition to his annual contribution of 8.5 per cent which is £14,008 gross.
Paying £14,968 in contributions and tax to buy an extra pension of £4,200 a year and extra cash of £12,840 looks like good value for money. The pension alone would cost between £100,000 and £120,000 on the open market.
Lifetime allowance calculation
2011 value = 20 x £74000 + £222,000 = £1,702,000
Lifetime allowance 2012 value (assuming Joe stays in the scheme and therefore does not claim fixed protection) = £78,200 x 20 + £234,840 = £1,798,840
If Joe leaves the scheme and claims fixed protection in 2011, then his lifetime allowance charge is £0, because his pension is valued at £1.702m which is below the £1.8m protected allowance.
However, if Joe stays in the scheme, he cannot claim fixed protection, as a condition of fixed protection is that accrual must cease. So, by staying in one extra year, his benefits now exceed the lifetime allowance by £298,840. This is taxed effectively at 55 per cent, meaning that Joe will pay tax of £164,362.
So, if he stays in, the cost is £164,362 + £14,968 (net contribution and annual allow tax charge) = £179,330. Suddenly, the extra pension of £4,200 plus extra cash of £12,840 no longer looks like such a great deal (value £110,000 to £130,000).