The challenges for clients tackling allowance charges in public sector schemes are getting even more complex
If you wanted to bet on what financial advisers hate most about the tax system, you should probably go for the lifetime or annual allowance.
If breaching either frustrates advisers, the dislike often intensifies when the tapered and money purchase annual allowance come into play too, as legislators constantly tinker with them to bring in some extra revenue.
In January, Prudential published research that shows the tapered annual allowance is the top concern for clients, while a Freedom of Information Act request from Curtis Banks to HM Revenue & Customs shows the number of people reporting annual allowance breaches more than doubled in the 2016/17 financial year when the tapered annual allowance was introduced.
Settling an annual allowance charge for a client in a group personal pension linked to an employer – to use an example – is fairly straightforward. This is because it is easy to calculate how much should be paid and whether it should be done using scheme pays rules, whereby an annual allowance charge is paid from the individual’s pension.
But these challenges are more complex in public sector schemes where an actuarial calculation is usually needed to work out any charges and the most tax-efficient way of paying them. That is because these were once final salary plans but they have steadily shifted to career average arrangements over the years.
The risk for advisers who have clients in public sector schemes is they might overestimate how much guaranteed income there will be at retirement and recommend an investment strategy that is too aggressive.
Advisers Money Marketing spoke to who have clients in the public sector say tackling the allowance problems is a constant struggle.
Health professionals in the NHS have received the most attention this year as there have been reports of more consultants and GPs being hit by higher allowance charges.
In many ways the NHS is the model case study of the various allowance issues advisers have to contend with because it is so complicated. But it is crucial to understand the political factors that affect public sector pensions as a whole before analysing any one scheme. These political forces drive the changes in legislation that affect clients’ retirement objectives.
Stephen Bridges, IFA, Antrams Financial Services
The number of my clients breaching the lifetime allowance has gone up extraordinarily, maybe by about a third. This is due to higher contributions, investment growth and the limit coming down.
They have been breaching the lifetime allowance at the start of their journey rather than the end. Nonetheless, lifetime allowance breaches also need to be reviewed at age 75. Many clients do not know about this but they need to be informed.
So whenever a client’s fund crystallises you have to control the growth of any capital remaining and watch it closely.
Politics shapes pensions
It is well known that politicians like to tinker with pensions tax relief and can use it to win favour with voters before a general election.
One only has to look at the way lawmakers are reluctant to weaken the triple lock on the state pension as older voters may turn against them if they did.
In June 2018 the government said it would spend an extra £20bn annually on the NHS by 2023. A month later, reports surfaced that the Treasury had started to investigate a flat-rate pension tax relief proposal that could raise an additional £4bn in revenues.
There were then reports last October that chancellor Philip Hammond might announce further cuts to pensions tax relief in the Budget to help fund the extra spending for the NHS.
Tax relief is currently assigned in line with a person’s marginal rate of income tax, which disproportionately distributes relief towards higher earners. The system means the government forgoes around £40bn in tax revenues a year.
The politics of pensions is also unavoidable in the public sector when the government is currently challenging a Court of Appeal ruling over how it treated certain professions. On 20 December 2018, the Court of Appeal ruled that the government’s transitional pension arrangements offered to some judges and firefighters amounted to unlawful discrimination.
The government announced the ruling could cost around £4bn a year if extended to all applicable public service pension schemes. The Treasury explained that schemes have made provisions of £29.5bn in respect of a potential increase in liabilities.
The British Medical Association also announced it would sue the government on the grounds of age discrimination because the underlying legal principles for doctors are essentially the same as the judges’ and firefighters’ case.
Quilter pensions expert Ian Browne says: “If the BMA’s age discrimination case is granted and the Court of Appeal decision cannot be successfully appealed, the government could face a significant cost as a result.
“For the government, managing the long-term expense of public sector pensions is a huge challenge. The generous terms were never really adjusted properly as life expectancies increased, and as a result the public sector pensions bill now represents one of the biggest expenditure items for the Treasury.
“If the appeal fails and the BMA is successful, then it is likely the chancellor will need to consider other measures to reduce the cost of these schemes without favouring older members.”
Jonathan Halberda, senior financial consultant, Wesleyan Financial Services
We are specialists and have a members’ advisory board of high-ranking NHS staff that meets quarterly and gives us information.
A lot of the clients are getting itchy feet because there is no carry forward anymore and I have NHS clients being charged up to £16,000 for annual allowance breaches.
We give guidance to clients about their options to pay these but do not give advice as it is too risky. What you advise really depends on the circumstances of each client and keeping on top of the nuances for NHS clients is critical.
NHS staff are also fighting a separate battle around pension tax allowances.
As was noted earlier, there have been reports of consultants and GPs being hit by higher allowance charges in the NHS and it is the sector which is experiencing the most difficulty.
The prevalence of allowance issues is higher among professions such as doctors rather than teachers, according to specialist advice firm Wesleyan.
A Wesleyan spokeswoman says: “At Wesleyan we are finding teachers experiencing lifetime allowance issues is quite rare compared to hospital doctors and GPs where salaries are higher.
“However, with the annual allowance being lowered some of our high salary head teachers are reaching the £40,000 mark when they are adding in additional funds, and when this happens our financial consultants do provide guidance.”
The anecdotal evidence is NHS workers are considering early retirement, part-time work and dropping out of the scheme altogether.
Yellowtail Financial Planning director Dennis Hall says: “Ten per cent of my clients are NHS dentists and 5 per cent of them are concerned about breaching the annual allowance.
“They have not left the scheme yet but might in the future as they might choose to retire earlier.
“Cashflow modelling does not work for public sector schemes that have career average benefits. An adviser can model benefits that are too high and you need to capture the accrued rate of benefits to estimate someone’s [retirement income] path correctly.”
The dangers for advisers who have clients in public sector schemes is they might overestimate how much guaranteed income there is at retirement and advise on an unnecessarily high-risk investment strategy. Advisers also have the problem of persuading clients to stay in the scheme as many appear to believe that staying in is not worth it.
A FOIA request by the Health Service Journal published in October 2018 found that 245,561 NHS staff had opted out of the NHS pension scheme in the past three years. According to calculations by Royal London, this represents around 16 per cent of the active membership of the scheme.
Royal London also looked at the large amount of pension rights that are being given up by individual NHS workers who opt out.
It says an NHS worker earning £25,000 per year currently has to pay a contribution of 7.1 per cent before tax relief. After tax relief, opting out would save them £1,420 per year.
But replacing that pension in retirement would cost a lump sum of around £13,000. This means that workers who opt out are giving up pensions worth around nine times what they save.
Independent pensions consultant John Ralfe recently broke down the tax implications of annual allowance breaches for NHS workers.
Ralfe says the income tax rate is 45 per cent on earnings of £150,000 or more, but the combination of the lifetime allowance and annual allowance ceilings means the effective tax rate on pensions earned is 62.5 per cent when total earnings and pensions top £150,000.
He points out these restrictions are easier to manage for higher earners in the private sector as they can simply avoid this higher tax by taking a lower pension in exchange for a taxable cash amount.
But life is not so simple for consultants as they must either stay in the inflexible NHS scheme for their full pensionable salary and pay higher tax, or they must leave the scheme and lose their valuable pension.
Ralfe also notes there are many consultants doing extra shifts every week, on top of their contracts to keep the NHS running, who also have a problem.
He says even though they do not earn any extra pension, as pensions are based on contractual salaries, extra earnings above £150,000 reduce pension tax relief, increasing their marginal income tax rate from 45 per cent to 67.5 per cent.
Given these massive tax charges, what can advisers do to help?
Sticking with the pension scheme in the long run will be worth it
Steve Webb, director of policy, Royal London
It is worth staying in the pension scheme and paying charges. One of the real challenges for advisers to help members to understand is the tapered annual allowance.
To have an annual allowance whose level can vary in-year and is calculated in an unnecessarily complicated way means that those who do not take expert advice will have little clue as to where they stand.
It is worth saying that it is not necessarily a bad idea to knowingly breach the annual allowance and to face a tax charge, especially where scheme pays is an option.
If the only alternative is to opt out of the NHS pension scheme altogether, the potential loss of future pension rights is substantial and could dwarf any annual tax charge. The government needs to look at the option of partial scheme membership which would allow higher earners to accrue at a reduced rate without opting out completely.
Chase de Vere Medical chartered financial planner Rachel Sartin says: “The three things NHS staff are always talking about with advisers is: will the cash lump sum be taxed? Will pensions tax relief be made less generous? What other bad news is there?
“From an adviser’s point of view, all these schemes provide a degree of security and a higher level of pension income for clients that advisers could not replicate through private pensions.
“It would cost me millions of pounds to get the equivalent of an NHS doctor’s pension. The idea for a client like this is you have a secured income and build the retirement plan around that.
“You would be slightly nuts not to stay in the scheme but the difficulty is clients do not understand the value of the benefits or when they are earning more money they are hit by allowance penalties.”
How can advisers approach clients who want to get out?
Sartin adds: “I try to stop clients looking through one end of the telescope at how much tax they are paying in the short term and think of the long term.
“How much guaranteed income do you need to live on? Think about when you will have no mortgage, kids and if you will still be married.
“These soft factors are a much better approach to planning retirement income than focusing on the negative news around taxation consequences. It is worth staying in the scheme even with the extra cost of being a member.
“The net pension after all the charges is still better than I could do for you anywhere else. The income is guaranteed, index-linked and government-backed, which is about as secure as it is going to get.”