Manse Capital Limited Financial Planners - Financial Planners, Wealth Managers, Tax Planners

Chapter 1: The Problem

Pension, pensions, pensions, will the story never end and why is it so important anyway?

In short, each successive Government since the mid 1980’s has deliberately swept the issue of retirement funding under the carpet leaving it to the next administration to sort out. Why? Simply because the problem is so vast and will require such draconian action to resolve it that it would be political suicide to attempt it. However the chickens are finally coming home to roost and with the problems now hugely exacerbated by the size of the national debt the penny is finally beginning to drop.

So why is there such a problem?

Some numbers:-

• £54.9 billion – pounds spent by the Government on the basic state pension in 2009/10, up from £48.8 billion in today’s prices only four years earlier.
• £3.5 billion – pounds the Government could save for every year the state pension age is raised.
• 12.2 million – people above state pension age in the UK – by 2050 this will have soared to 20.9 million if the age at which people can claim their pension is not raised.
• 12 – years men would live for after reaching 65 in 1950, according to the Office for National Statistics.
• 21 – the number of years men are now expected to live beyond 65. Women are likely to live for another 24 years, according to the Department for Work and Pensions. By 2050, it is likely a man who is already aged 65 will live for another 25 years and a woman will live for a further 28 years.
• The population of over 85s in the UK is forecast to increase by a third
  in the next 10 years.
• 4 – people of working age for every one person over the state pension age – by 2050 it is predicted there will be just two people of working age for every person who is retired thus halving the funding source for the basic state pension.

 

In other words we simply cannot afford to fund the current pensions regime and if we don’t do anything about it the current level of the national debt will be modest compared with the disaster that will unfold.

Chapter 2: The Hutton Report and Public v’s Private Sector

With the publication of the Hutton Report in to pensions, much was in the news last week concerning “gold plated” final salary tax payer funded pension schemes and the apparent unfair nature of these benefits compared with the money purchase schemes available to most in the private sector. Once again this is an issue that along with the basic state pension successive Governments have quietly ignored hoping it would go away. The truth of the matter however is that far from the problem going away it will simply get bigger. It is a pension structure that as a country we can’t afford to continue funding. So what are the suggested alternatives? Hutton makes some observations rather than recommendations and all of these do nothing more than state the obvious and mirror what is already under way in many private schemes and some public schemes. They are:-

1. Switch from a final salary scheme to an average lifetime earnings basis
2. Increase employee contributions
3. Increase the retirement age from 60 to 65

 

Let’s look at each point in turn:-

1. The impact of changing the basis of the final pension calculation would for higher earners in schemes like the NHS disadvantage the top Consultants who were looking to achieve significant Clinical Excellence Awards or Bronze, Silver or Gold awards in the latter stages of their careers. This is because the sizes of these awards currently contribute directly to the size of the pension they will be awarded, even if they are awarded them in the run up to retirement. Under the new scheme the impact of such awards on their pensions will be significantly reduced. It is worth noting however that the pensions of General Medical and Dental Practitioners are already on a lifetime career average earnings basis.
2. The impact of increasing member contributions to schemes will be relatively small. Even if they bring in lifetime average earnings the benefits that members will get back from the public schemes even if they raise contributions by say 5% are still hugely generous in comparison to private sector money purchase schemes on a pound for pound basis.
3. If they increase the retirement age from 60 to 65 for existing benefits accrued this will upset a lot of people’s planning and will mean people will either have to accept they are going to have to work longer or take action to accrue sufficient alternative capital and income sources to fund the gap between 60 and 65, if they still wish to be financially independent by age 60. In the long run however their long term financial security is still very high as the pension will still be largely tax payer funded and Government backed so there is no market risk once the income is in payment, though it will be dependent upon the continuing solvency of Government finances.

 

Thus if Hutton’s “observations” do come in to force it will undoubtedly require a rethink of many people’s longer term retirement plans. However the long term security of their position in terms of receiving a guaranteed pension for the rest of their life is still very good. They will just have to pay a little more for a little less and receive it a little later. It will still remain however a brilliant deal and unparalleled in most of the private sector. Our advice is at present to continue with the schemes.

Chapter 3: The Potential Tax Take

The above potential changes to public sector schemes represent a potentially significant opportunity to reduce the benefits under final salary schemes but this is not the only change we have to consider. Last week (14th October) the Government announced its plans to establish how it will calculate the notional “value” of membership of final salary schemes in terms of annual contributions. From the 14th of October the maximum pension contribution you can make from all sources has been reduced from £255,000 to £50,000 pa. This is called the Annual Allowance. If you exceed this level you are taxed on the excess at your highest marginal rate 20%, 40% or 50%). For final salary scheme members, because your pension is calculated on a final salary basis, if you receive a rise in income this rise in income is deemed to be a notional contribution for the calculation of Annual Allowance purposes and is therefore checked to see if it causes you to exceed the £50,000 limit. The new factor they use to calculate the value of any rise in income is 16X the increase in pension.  

For the vast majority of members of final salary occupational pension schemes the new changes will not give rise to a tax charge.

However here we use the example of a Consultant who has been a member of the NHS 1/80th final salary scheme for 30 years and obtains a Silver pay award in place of an existing Bronze award. This would give rise to a pensionable pay increase from £135,930 to £147,090 (ignoring on call supplements). Such a member would see their tax liability calculated as follows:

First the opening pension entitlement is calculated as £50,973 (30/80 of £135,930) plus the Tax Free Cash (TFC) of 3x the pension.

Next the opening annual pension entitlement is re-valued. If the individual had stopped accruing pension after 30 years, then the pension would have been up rated by the CPI. If the CPI increase is assumed to be 2.5%, then their pension earned after 30 years would have risen from £50,973 to £52,247 and the TFC to £156,742.

The closing pension entitlement is then calculated. If pension accrual instead continues, then their pension will rise to £56,997 pa (31/80 x £147,090) plus TFC of £170,991 as a result of the extra year’s service and the pay rise in the 31st year.

The increase in annual pension entitlement is therefore £4,748 (£56,997 – £52,247) and the increase in TFC is £14,249.

The increased pension is then multiplied by the new annual allowance factor of 16 to give a deemed contribution of £75,698 (16 x £4,748) plus the increase in TFC of £14,249 which is £40,231 in excess of the annual allowance of £50,000 (£90,217 – £50,000).

However, once deemed, the contribution can be tested against the individual’s annual allowance, taking account of possible unused allowance from the previous three years, and any charge due can be determined.

If this particular individual had received increases in pay of 2.5% per annum on the basic Consultant pay of £100,446 pa and the existing Bronze Award of £35,484 in their previous 3 years then their allowance in each of these three earlier years was as follows:-  3 x £50,000 pa so £150,000 but the increase in their contributions over those three years due to the 2.5% pay rises would have totalled  £159,086 (£50,963 + £53,005 + £55,117).

They therefore have no unused allowance from these earlier years and as such there would be a tax charge levied on the rise in pension value this year based on their marginal tax rate.

Thus they currently earn £100,446 basic salary plus Silver award of £46,644 so £147,090 (if there were no on call duties) thus £2,910 of the deemed contribution would be taxed at 40% so £1,164 (£150,000 – £147,090) with the balance being taxed at 50% as they are over the £150,000 earnings level. So a further £40,231 – £2,910 = £37,321 x 50% = £18,660. Total tax demand £18,660 + £1,164 = £19,824.

 

At this level we can therefore see that even being awarded a pay rise of 2.5% will trigger a deemed increase in pension contributions in excess of the £50,000 limit and hence a tax charge.

 

Chapter 4: Theft by Stealth

One change we know is coming in to force in all public sector schemes, is the rate at which the pensions in payment will be increased once they are drawn. Currently they are increased by RPI (Retail Prices Index) but the plans are to change this to CPI (Consumer Price Index). Each index is based on a basket of commodities and it is the subtle differences between the two baskets that will have the impact:-

• The RPI (Retail price index) includes mortgage interest payments. Thus changes in the interest rates effect the RPI. If interest rates are cut, it will reduce mortgage interest payments. Thus the RPI will fall but not the CPI.
• The RPI also includes council tax and some other housing costs not included in CPI
• The CPI includes some financial services not included in the RPI
• The CPI is based on a wider sample of the population for working out weights.

Historically the CPI has risen more slowly than the RPI and as such the long term prognosis for the increase in public sector pensions in payment is now less attractive than it used to be.

It is estimated that the difference between the two indexes equates to approximately 0.5% pa on average each year since 1989 (Office of National Statistics) Thus each year the rise in benefits under pension schemes due to inflation will be approximately 0.5%pa lower under CPI than RPI.

Thus if you retired at 65 and your pension was £40,000 pa indexed by CPI and the RPI averaged 3% and the CPI averaged 2.5% this would mean that by the age of 85 your pension would be £65,544 instead of  £72,244. This may not sound much but when you add up the cumulative effect of this 0.5% difference over the 20 year period using a starting pension of £40,000 the total loss in income is £59,728.

Conclusion:

The once bullet proof foundation stone on which many of our clients have built their long term retirement planning is under threat. The Government have to raise revenues and reduce benefits across the board. We still believe however that even if some of the changes detailed above do come in Government Statutory Pension Schemes such as the NHS, Teachers, Police and Fire Fighters schemes will still represent extremely good value for money when compared with the alternative which would be to de-opt and fund your retirement through personal pension provision.

What can we do About it?

Short of lobbying MP’s or industrial action there is not an awful lot that can be done to prevent at least some changes to retirement benefit schemes as the country simply can’t afford to continue to run them as they are. However, what can be done is to ensure when any changes are confirmed you are in a position to be able to react and re-plan accordingly. Thus once any announcements are confirmed we will keep our clients in touch with these changes and at annual review build these new assumptions in to their lifetime cash flow forecasts. This will enable us to map the impact of any changes and identify what action needs to be taken to help overcome any shortfalls that will exist in the future or to help in re-prioritising client objectives. This ability to qualify and quantify what a clients position will be post any changes will enable them to take remedial action immediately ensuring that the long term damage to their financial planning is minimised.

If you would like more information on anything contained within this article please just contact Baxter Fensham.

Sources:-

Office of National Statistics

Department of Work and Pensions

Tags: final salary pension scheme, financial advice, financial adviser for accountants, financial planner, Hutton Report, lifetime allowance, NHS Pension Scheme, Pension, pension indexation, Retirement Planning