NHS pensions and tax - it's not that simple

[This article was published shortly before the first DHSC consultation was issued in July 2019]

We are reading on daily basis about the challenges faced by senior NHS staff in relation to the tax charges on their pensions. Whilst I have yet to see any clear quantification of the link between pensions tax charges and service delivery, anecdote suggests that many clinicians are declining additional work because of pensions. Almost everyone agrees that the situation is untenable, and political promises have been made, but there is no easy solution.

No surprise

This could have been anticipated well in advance and it was not necessary to get to breaking point. Allowances have been dropping, pay has increased for many senior NHS staff (including extra shifts) and carry forward amounts are being used up. But when the already challenging topics of pensions and tax are combined it makes for a problem that needs to be seen to be believed. 

In order for this to be resolved at least one of two things need to be changed – the way we tax pensions or the design of public service pension schemes. Neither is easy and both would come with wider implications.

Taper or not taper, that is the question

The now infamous “taper” is considered to be the villain. The taper means that extra earnings increase the amount of tax charges, even if those earnings are not pensionable. The maths can suggest that the tax charges can offset increase in net pay if earnings are in the range ￡110,000 to ￡165,000 a year. Very few people are prepared to work for nothing.

There is no question that the taper is very complicated and difficult to manage. Earnings from all sources need to be included and the ￡110,000 earnings test creates an uncomfortable cliff edge. However, the rules are the same for everyone, regardless of where they work and what sort of pension they have. So why is this such a big issue in the NHS?

Policy intention

If you look back into to the development of policy leading up to the introduction of the Lifetime Allowance and Annual Allowance it’s clear that it was not the government’s intention to collect tax charges, rather that pension accrual should be limited to avoid excessive tax relief. It follows then that, unless the government was seeking to reduce total reward for high earners as well as tax relief, it is reasonable for an employer to provide taxable pay in lieu of pensions above the allowances. Most, if not all, employers with their own pension schemes and pay flexibility have done this to good effect. However, NHS employers have neither and this is the primary cause of the problems we are seeing today.

Flexibility

My preference is to resolve this challenge with a change to the pension scheme, not the tax system. The tax system may yet require change, but the NHS Pension Scheme does not need to be the reason for this. I would suggest two main changes:

• NHS employers are enabled to pay additional salary in lieu of pension foregone
• NHS members are allowed to select their level of participation from 100% down to 0%

The possible offer of a 50:50 scheme, shortly to be consulted on, whereby members pay half to get half is generally disliked. But this does not mean that flexibility does not work and a change in the tax system is better, because it is too crude an attempt at offering flexibility: the employee loses value and there is no particular reason why 50% participation is better than being fully in or fully out of the scheme.

In addition to the above, in order to limit tax charges arising from a salary increase in the final salary schemes, the amount of increase which is pensionable in these schemes should be flexible.

Fair for all

It is already possible for NHS trusts to offer a salary supplement, and some have, but many decisions makers have been understandably cautious. The policy intention is rarely understood, is difficult to articulate and there remains an important question around where to draw the line. Maybe other staff would also appreciate cash in lieu of pension and more flexibility?

Ever since the new pensions “Freedom and Choice” regime was introduced I have been clear that public service pension schemes need to become more flexible to survive. It is simply not sustainable to have to diametrically opposed pension regimes running alongside each other. And now, at the same time that the pensions tax issues are reaching boiling point, this is becoming clear. There is a marked increase in lower earning NHS staff leaving the scheme to increase their net pay. But they get nothing back from the employer, which is not inclusive: pay gaps, including gender and other pay gaps, are being widened. A real pay gap needs to include the value of a pension.

So the best solution for the higher earners is also the best solution for the lowest earners. In my view, this means we have a solution which is fair for all.

Not that simple

Despite the current predicament being highly predictable, even as little as two years ago very few people would have supported introducing flexibilities. It would have been seen as a dangerous dilution of the scheme and, of course, an administrative nightmare. Now there is a growing consensus around the arguments I have put forward above.

However, it is not that simple. And I am not talking about the administrative challenges. These would be tough, but with a CARE scheme being an annual (or even monthly) benefit “credit”, these are not dissimilar to those faced by Defined Contribution schemes.

The main barriers are cash and communication; and they are connected.

Cash

At the moment, the Treasury receives contributions from members and employers and pension benefits are paid in many years’ time. Therefore, every member who chooses to leave the scheme will divert cash from the Treasury to themselves. With cashflow being of utmost importance to the Treasury, it is only when HMT sees the disadvantages of the current system in value terms that things will move in the right direction. It is important that the Treasury carries out a robust value-for-money test in this respect.

Communication

There is no doubt that the NHS Pension Scheme is the right thing for the majority of eligible staff. If members are tempted by cash without thinking, it could result in a lack of retirement provision and also a significant cash impact for the Treasury (in line with the comments above). A way to mitigate this is for the significant value of the pension scheme to be very clearly articulated. If you consider the cost to an individual of having to replicate the benefits, this is can be much higher than the employer contributions.

There is a challenge around whether unions are comfortable with the true value of the benefits to be articulated in this way. It would push pensions towards being a clearer part of reward and it may shift the analysis around public sector versus private sector pay in favour of public servants.

Tax changes: careful what you wish for

The cash and communication challenges may create an impasse which is difficult to resolve in the short-term. This may lead to a tax solution being sought. If, as has already been suggested by the Chief Secretary to the Treasury, the system needs to change for all (not just the NHS) and needs to be made more simple, this would have significant implications for public service pension schemes. For example, replacing the taper with a lower Annual Allowance overall. In terms of more radical change, a so-called “single rate of pensions tax relief” would likely require adjusting benefit credits and debits for every member in every year, and would be unworkable for the current scheme.

Wider reform

Pensions taxation remains an untapped source of revenue for the Treasury and a single rate of pensions tax relief is a distinct possibility at some point in the near future. If you also consider that the government’s lost age discrimination case (“McCloud) will necessarily prompt a significant review of public service pension schemes, it is unlikely that the current schemes will last the 25 years as intended following Lord Hutton’s independent review.

In my view, moving public service pension schemes to become more flexible as quickly as possible will move them in the direction they need to go, whilst making sure that the NHS tail doesn’t wag the pensions tax dog.

Mind the gap: guidance

Whatever happens, senior NHS staff are currently struggling with the current regime. This is causing feelings of confusion, uncertainty and anger. It is vital that the individuals concerned have access to information and education which enables them to understand their position. For many, it will not be as bad as they might have feared based on some of the headlines. For those for whom it is bad, they need to be able to deal with it quickly and effectively, with accurate tax returns.

Obtaining individual advice on tax issues relating to the NHS Pensions is expensive given the level of complexity and specialism involved. However, advice is often not necessary. With the right information to hand and with good education, those affected can receive the guidance they need in order to improve service delivery outcomes. The pensions industry should gear up to provide good guidance in innovative and engaging ways. Whilst this will always be needed, in the short-term this is a crucial part of the solution to the current NHS pensions tax crisis.