The Agony of the Annual Allowance
Recent articles reporting the furore around the annual allowance (AA) and how it ‘unfairly’ impacts on certain individuals in public sector defined benefit (DB) schemes piqued my interest. Adding fuel to the fire was the news that the British Medical Association (BMA) is reportedly calling on the government to reform both the AA and the tapered AA for doctors in the NHS pension scheme. In addition it has been suggested that doctors and other public sector workers are taking early retirement to avoid the lifetime allowance (LTA) charge as well.
Regarding the latter, my personal feeling is the LTA should be scrapped for other money purchase arrangements for the simple reason that the individual carries all the investment risk in their pension. However, I do not believe in such action for public sector DB arrangements as the member carries no investment risk whatsoever, and indeed many of these schemes ultimately are underpinned by the taxpayer universe as a whole.
Getting back to the AA, given the number of comments made on the websites following the publication of some of these articles, it got me thinking what all the fuss was about.
In the case of a DB arrangement, calculating the pension input amount (this is the pension savings figure that is measured against the individual’s AA) is slightly more complicated than that for other money purchase arrangements. It is not, as may be envisaged, a case of using the percentages for employer and employee contributions and applying these percentages to the member’s pensionable earnings. Rather, the pension input amount (PIA) for a DB arrangement is a notional contribution based on the increase in the member’s benefits accrued over the pension input period (PIP).
Taking the NHS scheme as the basis for an example to work through; for someone with pensionable income of £111,377 or more, personal contributions are set at 14.5% of their pensionable income and employer contributions at 14.3%, with an additional levy of 0.08% for the latter. A recent Department of Health and Social Care consultation recommended that employer contributions be increased to 20.6% from 1st April 2019, though member contributions are to stay the same.
Keeping things relatively straightforward we will presume the individual in question – let’s call him Dr Strangelove – is a member of the 1995 Section of the NHS pension scheme and will remain so until retirement. He is accruing pension income benefits on the basis of 1/80th for each year of service, with 3/80th for his pension commencement lump sum (PCLS). At the start of the PIP, his NHS pensionable income was £137,931 and he had 34 years pensionable service. At the end of the current PIP it is presumed he has 35 years service and his NHS pensionable income is £140,000. CPI in September 2017 was 3.0%.
Let us also presume Dr Strangelove has private practice income of £20,000 and so has threshold income of £139,700 (£160,000 – £20,300), and adjusted income of £160,000 (for the purposes of tapering, due to the methodology, there is deemed to be no employer contribution in this scenario, i.e. £16,537 PIA minus personal contribution of £20,300). His tapered AA is therefore £35,000 (£40,000 – £5,000) leaving him with £18,463 to carry forward.
The fortunate Dr Strangelove has accrued uplift on his index linked pension benefits worth £2,629, (ignoring the uplift in PCLS), for a PIA amount of £16,537. Solely for comparison purposes, let us presume this accrual is for an individual in the year they take benefits, and contrast this with the significantly lower benefits another money purchase arrangement PIA of £16,537 would secure through the immediate purchase of an RPI linked annuity with 50% spouse’s pension. Just to compound this issue, the actual capital value of the contributions made to a DB arrangement can be significantly higher than the calculated PIA. Assuming a total contribution of 28.8% of NHS pensionable income, in our example Dr Strangelove’s contribution in monetary terms would be £40,320 (28.8% of £140,000), £23,783 higher than the actual PIA for AA purposes.
Many would call this ‘unfair’, and it is probably one bomb the BMA should avoid setting off.
This article first appeared in Money Marketing