What are the differences between NHS pensions and private pensions?
Dental specialist financial adviser Daniel Nixon discusses the frequently asked question regarding the differences between NHS pensions and private pensions.
The NHS pension scheme
The NHS pension scheme (NHSPS) is a defined benefit scheme. This means the scheme promises to pay a guaranteed income when you retire, which for a practitioner is based entirely around their career average revalued earnings (CARE). For a dentist who has worked in a salaried setting prior to 2015, this will instead be based upon a combination of their income and length of service whilst salaried and the CARE basis for anytime spent as a practitioner or for salaried membership beyond 2015.
The NHSPS comes with a variety of benefits including an ill health retirement pension, a spouse’s pension and a dependents’ pension, if you were to die before you reach retirement age. These benefits when viewed by a financial planner are attractive as fringe benefits as they provide an NHS pension scheme member and their family with various forms of safety nets, which simply are not available within a private pension.
This, combined with the fact that being a defined benefit scheme means that the amount you receive is guaranteed by the government, makes the NHSPS a particularly valuable one.
How do NHS pensions work?
The contribution made is based upon a percentage of how much you earn. For example, if you’ve earned ￡100,000 in the current tax year that would be approximately ￡12,500 a year cost in pension contribution.
As an active member, if you were to earn the same ￡100,000 of NHS income in the current year, in simplified terms you would earn one 54th of that as new pension. That means ￡1,851.85 would be added to your final pension. However, that wouldn’t be where it ends as the pension will forever be inflation linked until the day that you retire as part of your overall CARE pot. Therefore, the contribution to your final pension at the point that you retire would be much bigger. The advantage of this is that you paid a fixed price for those benefits.
What are the benefits of NHS pensions?
If you look at this in very simple terms and don’t include tax relief on the contribution cost or inflation of the pension you have bought, you can see what exceptional value the NHSPS provides. Simply taking the ￡1,851.85 pension earned and dividing it by the cost of that year’s ￡12,500 contribution tells you in laymen’s terms that after seven years of retirement the pension contribution has more than been recouped by the income paid. Most dentists retiring today would have aspirations of a much longer retirement than this time span. This is one of the reasons the NHSPS is held in such high regard.
The reality is even more beneficial as due to inflation linking, it will take even less time to recoup the contribution cost as by the time the dentist retires, the ￡1,851.85 pension payment will have increased with inflation, and will continue to do so post-retirement.
However, it is important to note that once you have died and your spouse has died, an NHS pension has no further value to pass on to anybody as it can’t be inherited.
Private pensions
A private pension is a defined contribution pension. This means that you build up a pot of money which can be used to provide an income in retirement.
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The only element to this type of pension that is controlled is how much you pay into it. This would be an amount that’s affordable to you. It could be monthly, quarterly, half yearly, in lump sum payments or whenever you can afford to do so. The funds from private pensions can be put into investment funds of varying risk levels based upon the risk profile of the client – how much you get back in the future depends on how much you paid into the pension and how the investments perform.
Some dentists choose to pay into their pensions every January, based upon the guidance of their accountant in relation to strategic tax planning. This payment would typically be invested in line with a risk appetite determined during a review with your dental specialist financial adviser. It might go into one fund or into several, but ultimately, the funds would be aligned to the general risk theme suited to the client’s circumstances.
With a private pension, when you retire, instead of having a set amount of income per year as a pension, you would have a set fund value. This could be better described as a savings pot worth a set amount of money. Once you reach retirement age, you have several options as to how you choose to use this capital to support you.
Flexible access drawdown
Currently the most popular option among dentists tends to be to use flexible access drawdown (FAD) where you can choose what you draw from your pension without limitations. For example, if you had a pot of ￡500,000 you could withdraw it all in the first year if you wished to do so – this is not necessarily a sensible strategy, but it is possible.
What is more likely, as part of good financial planning, would be to choose to withdraw a sustainable percentage of the funds every year – for example, perhaps around 4% per year. This could mean that the value you withdraw each year, the 4% would hopefully be almost fully replaced by investment growth.
The aim of withdrawing a sustainable amount is to try to ensure that your pot lives for as long as you do with minimal year-on-year depletion. This is because many people opt to take a more defensive investment strategy once they have reached retirement than they do whilst building the money up. This defensive approach is often considered a more sensible one, given that none of us have the luxury of knowing how long our retirement will last.
What are the benefits of private pensions?
The benefits of this approach include the flexibility in terms of how much you want to take out year on year. This can be advantageous for tax planning particularly when the state pension kicks in, with many dentists then choosing to reduce their income withdrawals from their FAD as a result of their increased income.
A final significant advantage is that a private pension is inheritable when you die. There are different ways and tax implications of passing on your unspent pension but one of the most popular currently is to assign your leftover funds to your children, where depending on your age and pension situation at time of death, they can benefit from either a lump sum or a regular income from your pension plan. This is a clear advantage over the NHS pension scheme.
Which one should you choose?
NHS pensions and private pensions are very different means of getting to the same end point, which is income security in retirement. The NHS pension scheme still offers exceptional value and should be the primary consideration for those working in the NHS and looking to build income for the future.
In recent years we have however, seen more and more dentists working privately whether that be fully or partially – those dentists unable to direct this income towards the NHSPS should consider seeking further guidance to understand the benefits and flexibility of private pension planning, ensuring that they do so in a joined up approach that considers the opinion of both a dental specialist adviser as well as a specialist accountant to ensure maximum efficiency in both tax and retirement planning.
Bear in mind that the value of investments can go down as well as up and you may get back less than you invest. Tax treatment depends on individual circumstances and may be subject to change in future.
For further support and guidance to plan for the financial year ahead, speak to a dental specialist financial adviser at Wesleyan Financial Services by booking a no-obligation financial review or calling 0800 316 3784.