Not in a final salary scheme? Expect a smaller pension or a higher tax bill

In this week’s magazine, we have a look at how changes to pensions allowances will affect those with good-sized pensions (subscribers can look at this on Thursday, but the answer is mostly badly). But along the way, I was struck once again by the huge advantages in having a defined benefits pension of any kind.

*At the moment everyone gets relief at their marginal rate of income tax, be that 20%, 40% or 45%.

From this April, the lifetime allowance for pension savings will be moved to £1.25m. The tax authorities measure the size of a defined benefit pension pot by multiplying the annual payment the recipient is entitled to by 20 times. So, only those with an annual entitlement of more than £62,500 at the moment will end up having any trouble with the new rules.

But what of those of us with no defined benefits? What if we are saving into personal pensions on a defined contributions basis? Right now, £1.25m buys an inflation-linked annuity of around £35,600 a year. You see the point.

A member of a final salary scheme gets not far off double the annual pension as someone in a defined contribution scheme before they find themselves over running the government’s new limits and paying a 55% flat tax on the excess. Enough to make a person want a job in the public sector, isn’t it?

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  • mr clyde

    MSW’s arithmetic is spot on, and I would agree that the conversion factor of 20 is way too low. However, other than ‘the politics of envy’, what is the point of this article? When I started out on my public service career the pension scheme on offer was not much different to most others, and the government has quite reasonably done nothing more than honour its obligation. Yes, I now appear to have got lucky, but not so lucky as a number of my acquaintances who are sitting on a £1m+ profit on their houses, and that’s completely tax free and can be passed on to their grateful heirs.

  • loads2

    Dear Mr Clyde

    Dont get me started on your own “politics of envy” stuff. As a professional interim in the public sector it is blindingly obvious that all public sector workers are bitter, twisted, resentful and totally narrow minded to the REAL world (that Mervyn and others on Moneyweek report on).

    As a professional contractor working in the public sector, i am delighted the public sector is like this. It creates work for me and many others to be parachuted in to sort things out that public sector workers cant do.

    work it out for yourself. you want say £20k pa as a pension index linked. that means you (or rather the taxpayer) must fund your pension scheme to the tune of 20 to 40 times more ie £400k to £800k. Most workers in the real world cant rely on the taxpayer paying this for them; so they have to forego consumption to fund it themselves

    Yesterday, my wife and I were struck with seeing 2 porsches and a top of the range merc parked in the teachers’ bays at local comprehensive school car park. its such a hard life being a teacher isnt it?!!

    like all public sector workers teachers contribute single digit % into their pension while the taxpayer contributes the lion share. all that money that teachers and other public sector workers are saving by not putting in enough into their pensions means spare cash for consumption on porsches and mercs.

    leave your politics of envy rubbish aside and wake up to the fact that someone with £300k in a SIPP and a house isnt a “millionaire” but a future impoverished pensioner paying for the cosy retirement of public sector workers

  • Salient Point

    You make a very important point, but I believe that in an important respect it is incorrect. I have just completed a model to assess the likely effect of the £1,250,000 cap on a relative. The article did not mention that there is a deadline of April 5th to make an election to cease contributions to all the schemes of which a person is a member. The effect of this is to increase the limit to £1,500,000, so it is an important decision.

    Where I think it is wrong is in ignoring inflation. If it is correct, then my model is wrong. There is no reason to believe that the thresholds will be increased to allow for future inflation. On the contrary, the LTA has been reduced a number of times since it was first introduced by the last government, a process continued by this government. What has to be assessed is whether or not the value of a person’s pension fund is likely to be above the threshold at the point at which the pension can be taken. It is more complicated than that because this can also be assessed on some other events, but that is the first consideration.

    What this means is that likely inflation has to be taken into account. That is an unknown, which why I have constructed what might be called a model, rather than simply undertaken a calculation. It enables a range of possibilities to be considered. There are variables other than inflation which have to be considered (including future real salary changes and how long the person concerned will remain with the employer) which are also unknown, and which are included in the model (which is merely for private use).

    I would not have gone into such detail had you not seemingly undermined the basis on which the relative I am advising has to make an important decision. I therefore invite you to either justify your argument, or concede that it is wrong. I hope that you are right, but believe that you are not.

  • Romford_Dave

    I see the point Merryn, but it is an erroneous one.

    Putting aside for one moment the sensibility of anyone opting for an annuity, we should all be aware that the poor return on annuities is due in no small part to the suppressed return on UK gilts used in the calculation at the moment.

    If gilt returns rise, which we are routinely assured (by you know who) they will, then the figures used in the comparison will change and lessen or even reverse
    the difference o to what it once was before.

    There’s nothing to stop people contributing more to their pension should they choose to, other than the loss of the benefit that is tax relief.

    How much tax relief would you have other tax payers provide for those fortunate enough to contribute 6 figure sums to their pension pot?

  • inigo5j

    Dave Romford has hit the nail on the head: no-one is forced to buy an annuity now: drawdown is always an option. £1.25m divided by 62,500 will last a lot of years even if you only assume a 2% real return on the unspent capital. The press is up in arms because people buying annuities often don’t make the right choice. Surely it is not government’s role to make sure all citizens always make what it thinks are the right choices. If the basic state pension is enough to live on somewhere in the UK (not necessarily where the citizen chooses ) then there is no obvious reason for the government to subsidise saving into a pension at all. Because pensions are a long term commitment, arguably the government is doing the right thing in committing to a realistic basic state pension and gradually withdrawing an inappropriate subsidy to the pension industry.

  • Borderer

    Please also consider that many public sector workers have the option to retire from the age of 55 should they have sufficient years of service, meaning their real ‘pension pot’ is a higher multiple than 20x.

    The rules are designed by civil servants and taxmen. What kind of pension are they on, I wonder?

    Or am I just guilty of the politics of envy?

  • Critic Al Rick

    Politics of envy! Isn’t it sometimes said that politics is the art of the possible?

    You don’t need to apply much common-sense to the situation, vis a vis some Public Sector Employment, Pensions and Salaries, to see that many of the present arrangements are, without parasiting off the Truly Private Sector (TPS), totally unsustainable in the very short term and, parasiting off the TPS, totally unsustainable in the longer term.

    In the longer term, one way or another, PS Employment, Pension arrangements and Salary arrangements will have to be greatly reduced; because the TPS is finite and cannot sustain the level of PS Parasitism placed upon it indefinitely; let alone withstand the Parasitism of the remainder of the CeS(pit) (Cartel, etc Sector).

    Politics of envy! Isn’t it sometimes said that Politics is the art of making the inevitable look like wise human deliberation?

    The status quo is highly unlikely to change much due to wise human deliberation; but I can foresee Politics being the inevitable art of possible Revolution.

  • L russell

    Dear loads2, you have no idea how the Porsches were paid for, do you know if they even belong to teachers? All public sector workers are not bitter and twisted. You sound it though.

    My experience of private sector workers contracting to the public sector is that they do very nicely out of the Public sector with their closed shop approved contractors .lists

  • mr clyde

    Thank you L Russell – my point exactly.

  • dave21kj

    Seeing exactly the politics of envy.
    The real issue is that the country is broke of course. Public sector wage rates are pegged to the market, and part of the deal they signed up to was a pension. Which we all used to enjoy. Successive governments ran deficits and we are collectively guilty for allowing this to happen. (Provided someone else pays in seems). We are happy to pay for Falklands war, first gulf war and Tony Blair’s 7 wars. We are happy to borrow and spend and ignore commitments made.
    Sometimes you reap what you sew. Except of course the current pensioners who seem to have spent and left the bill to their off-spring! Or is this the politics of envy..

  • 4caster

    “Enough to make a person want a job in the public sector, isn’t it?”, writes Merryn.
    Those working in the private sector and nudging the £1.25 million limit will take one look at the salary of any public sector job open to them, and throw up their hands in horror.
    Public sector pensions of £62,500 are only paid in the high-flying league of NHS Consultants and Army Generals. You can’t transfer to the army from the private sector and enter as a General. And no Consultant would work solely for an NHS salary and pension. They all moonlight.
    The present abnormally low annuity rates were artificially created through the 0.5% base rate and QE, necessary consequences of the 2008 banking crisis. They will not last for ever, but now is the wrong time to impose this cap on pension pots.

  • DaveW

    It is interesting to see that criticism is so often levelled at “generous” defined benefit pension schemes rather than at the appalling returns offered by the annuity market. Who, in their right mind, would voluntarily part with £1.25m in return for an income of £35,600pa. At that rate it would take over 35 years to return the capital alone. Someone retiring at 65 would have to live to the age of 100 years just to get their own money back, let alone see a return on their investment. See my point? A very simple spreadsheet model shows that an average return of just 2%pa would provide a pension of the same amount for over 58 years. Put another way, given a life expectancy of 100 years of age £1.25m provides enough for a pension of £49,000pa over 35 years with that average return of 2%. That means that the finance industry is taking out at least £13,400pa for doing no more than putting the money in a savings account at 2%pa. over 35 years.

    It is obviously true that defined benefit schemes provide better pensions, whether in the private sector or in the public sector. The reason for that is equally obvious. Those schemes are usually managed by trustees who have a conservative investment strategy and pay for expert advice rather than paying a deceptively small sounding percentage of the fund each year in complex charges. Other administrative costs are simply charged to the pension fund without a mark up. The funds are actuarially valued every 3 years and the liabilities balanced to the assets to avoid surprises. Increases in life expectancy don’t come as a shock, volatility in the market is smoothed out over lifetimes and the funds do the job they were intended to by providing contributors with a decent income during retirement. The biggest shocks to pension funds were the removal of tax relief on dividends and the introduction of FRS17, which made funds value their assets at current market rates against liabilities that would mature over working lifetimes of up to 45 years. That resulted in the same sort of volatility that we see in the stock market, throwing up artificial “surpluses” in good years that allowed employers to reduce contributions, or even take contribution “holidays” followed by “black holes” in the bad years. The main purpose of the fund as a mechanism for smoothing out costs over an employees lifetime and protecting against volatility was destroyed by a short sighted accounting rule. Defined benefit pensions started in the time of Samuel Pepys and fulfilled their purpose admirably until recently. We shouldn’t be criticising them, we should recognise their value, protect them and ensure that everyone has access to them. Don’t be jealous of defined benefit schemes, recognise the inadequacies of the annuity market as a vehicle for providing retirement income and ensure that everyone gets access to a properly run, transparent pension scheme.

  • Boris MacDonut

    There is no pension pot in the public sector. The pension is a ponzi. The average civil service pension in payment is under £8,000pa. In addition there has been no pay rise for 5 years while pension contributions have been raised by 5.5%.

    • Critic Al Rick

      Steps in the right direction; but a long, long way to go before the effective ‘feeders’, as a whole, of the ponzi can sustainably feed, let alone pension, themselves.

      Unless, of course, we’re sustainably inundated with multi-millions of spendthrift Chinese tourists each year, sometime soon.

      • Boris MacDonut

        Current shortfall is £6billionpa but this covers 6 million pensioners and 6million workers.

  • Merryn

    More on the tax payable on pensions over the LTA here http://moneyweek.com/beware-you-may-be-saving-too-much-in-your-pension/

  • Merryn

    And yet more on the matter – why one reader thinks the LTA is just fine – as a manageable wealth tax. http://moneyweek.com/merryns-blog/a-wealth-tax-worth-paying/

  • I read this as meaning I could apply for ‘fixed protection’ now, if I ceased making further contributions. Not as simple as that. As well as there being varieties of ‘protection’, none of them seem to apply unless you already have, now or on 5/4/2014

    Deliberately paying in to exceed LTA seems risky, since it makes multiple assumptions, none of which can be relied upon i.e. income, capital gains, NI, LTA and pension contributions tax structures and rates will not alter detrimentally to the strategy, over the next couple of decades. But good luck to him.

  • Merryn

    The detail should anyone want it on fixed protection etc is here http://www.hmrc.gov.uk/pensionschemes/pension-savings-la.htm

  • CKP

    A minor point but enough to make a significant difference:

    Public sector final salary pensions are linked to CPI. Open market index linked annuities are generally linked to RPI and therefore more valuable over the long term.

  • Merryn

    Amazingly even the MP pension scheme has now switched to CPI http://www.parliament.uk/briefing-papers/SN06283/mps-pension-scheme-2012-onwards

  • Sean Davies

    “Separately, Mr Alexander also announced that government departments were not contributing enough to their employees’ pension funds.

    But it is already clear that these will show the level of contributions paid by employers have not been sufficient to meet the full long-term costs of these schemes. If current rates were allowed to continue, the shortfall would be nearly £1bn a year across the teachers’, civil service and NHS schemes. The government is therefore taking corrective action, and will introduce new higher employer contribution rates for these schemes from 2015. This will ensure that the contributions paid by public service employers reflect the full costs of the schemes, including the costs of the deficits that have arisen since previous valuations.

    This will not have any impact on existing pensioners, on member benefits, or on the contributions paid by employees in those schemes. Instead it will ensure that pension costs are properly met by employers and do not fall as an additional cost to the taxpayer.”

    Re: that final point, I bet it will!!!

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