What to do when you hit the pensions cap

Angry anaesthetist © Alamy
The BMA fears experienced staff could leave if pension rulings aren’t changed

High earners running up against pension caps should do their sums, says David Prosser.

Should you give up work to avoid a nasty tax bill? This, apparently, is the dilemma now facing doctors in danger of reaching caps on pension-contribution limits. The generosity of the defined-benefit (DB) NHS pension scheme means many are incurring extra tax charges, either as they near retirement, or when they take on overtime and extra work. The British Medical Association (BMA)thinks the problem is so acute we need to change the rules in order to avoid losing crucial frontline staff from the NHS.

However, it’s not just high-earning doctors who find themselves in a tricky spot. The annual allowance, limiting the amount of pension contributions you can make each tax year, and the lifetime allowance (LTA), a cap on the total size of your pension fund, apply to all savers. Most people don’t get anywhere near them, but if you’re a member of a DB scheme, you’re more likely to exceed the limits. This is partly because the rules are complex on how contributions and pension rights in such schemes are valued. But DB pensions also offer more valuable benefits than other arrangements.

But are these savers really facing such bleak choices? The BMA argues that once doctors start running into additional tax charges they have no incentive to carry on working.In truth, however, the sums don’t stack up in quite this way. The tax charge for those who breach the annual allowance is calculated according to their income, but for most people is likely to work out at between 40% and 45% of the excess. In other words, more than half the cash is still going into their pension. Nor does the charge have to be paid upfront – you can usually elect to have your pension scheme pay it, with your benefits reduced accordingly. Similarly, the LTA stipulates a 55% charge on lump-sum withdrawals over the cap (currently £1.055m). No-one wants to pay that much tax, but there’s still a benefit remaining.

There are some complications to take into account. In particular, income from overtime is typically non-pensionable, so you don’t get extra pension from it, but it does count towards your total income for the year. Since higher earners get a reduced annual allowance, this causes a problem for small numbers of people, though in most cases their additional exposure to an annual allowance charge will be cancelled out by their extra earnings.

Fees cap could be limiting returns

The damaging effect of high fees on your investment returns is well documented. So the government edict that workplace pension funds must not charge more than 0.75% a year (implemented in April 2015) seems eminently sensible.

But there’s a problem, says the Association of Investment Companies (AIC), a trade body: fund managers offering exposure to illiquid assets such as private equity and infrastructure have higher costs and are struggling to keep fees under the cap.

As a result, workplace pension scheme members may not get the opportunity to invest in such funds, and therefore could be missing out.

The AIC’s warning follows a review of the charges cap announced by ministers earlier this year. The government is eager to persuade pension schemes to invest more in infrastructure, so it’s considering relaxing the rules. However, if it does so, pension scheme members will need to think carefully about their fund choices.

It’s true, as the AIC says, that some private-equity and infrastructure funds have a record of outperformance – this may be worth paying extra for. However, not every fund of this type outperforms, in which case the higher fee would be part of a double-whammy effect that depresses your pension-fund returns.