Over the past week or so there is growing media reporting on the impact of the pensions Annual Allowance, and in particular, the Tapered Annual Allowance on doctors. The reports are quite troubling. Many doctors reducing hours to avoid punitive tax charges, leaving health services critically understaffed. Enormous tax charges that leave doctors with difficult financial choices.
So why is this hitting doctors? What is special about them?
In this post, I explain the particular circumstances why it affects doctors.
First, let’s look at what the Annual Allowance and Tapered Annual Allowance are.
What is the Annual Allowance
From my 2018 post on the Annual Allowance:
The Annual Allowance for 2018/19 is £40,000. What happens is this: if your total contributions into your pensions are greater than £40,000 you will have to pay a tax charge. This tax charge is the top marginal income tax rate on the excess above the AA.
As I mentioned in my Lifetime Allowance post, when you put money into a pension the Government provides tax-relief. The underlying principle under the pension tax-relief system is that you defer taxes.
With the Annual Allowance, the Government is basically capping the amount of tax relief they will give you in a year. In effect, the Government is saying: “you’ve got enough from us, you’re on your own now”.
What is the Tapered Annual Allowance?
The Tapered Annual Allowance is an additional, fiendishly complicated allowance. From my 2018 post on the Annual Allowance:
In 2016/17 the Government introduced the Tapered Annual Allowance (TAA). Aimed at ‘high earners’, the Annual Allowance is reduced for people who have ‘adjusted income’ over £150,000 and ‘threshold income’ over £110,000 a year. The AA reduces by £1 for every £2 over £150,000 down to a minimum of £10,000.
As noted above, both adjusted income and threshold income need to be above the limits. If you are over only one of the limits, the taper doesn’t apply.
Why does it especially hit doctors?
There are 6 reasons which, collectively, mean doctors are particularly vulnerable to the Tapered Annual Allowance:
1. They have high incomes
The Tapered Annual Allowance only comes into play if you have a high income. By high, we are talking more than £110,000. That, of course, is different from being ‘well paid’.
2. Doctors can have variable incomes
Many doctors work extra shifts and overtime. This work is typically non-pensionable (if it’s outside their contractual arrangements). But it means that knowing in advance exact yearly income is very difficult (or impossible). This is unlike many high earners who are typically salaried by one company with no overtime, meaning their year on year incomes are more knowable.
3. They are in a Defined Benefit pension scheme
This means three things. First, their pension ‘accrues’ or increases at much higher levels than typical Defined Contribution pensions. Second, it means the amounts contributed towards the pension are much higher too. Thirdly, in a Defined Benefit scheme, you don’t know the contributions levels until after the year ends.
This is important as: (1) accruing high levels of pension puts you closer to, or in excess of, the annual allowance of £40,000. (2) the higher levels of contribution mean that adjusted income is liable to be far higher than threshold income, sometimes far in excess of £40,000. (3) The lack of visibility of contribution levels in advance make financial planning very challenging.
4. The NHS pension scheme is inflexible
It’s an opt-in or opt-out deal. Unlike with a private Defined Contribution scheme, a doctor can’t cut contributions if they think they’ll breach the Annual Allowance.
Likewise, there is, as far as I’m aware, little to no ability to negotiate alternative compensation arrangements in lieu of employer pension contributions if it looks like they will breach the Tapered Annual Allowance. I’m aware of several private employers who, when faced with the administrative burden of dealing with the Tapered Annual Allowance have said: stuff that, we’ll arrange for alternative compensation instead.
5. The NHS Pension Scheme is Unfunded
Most pension schemes are ‘Funded’. This means the scheme holds assets from contributions against future liabilities (future pension payments). On an individual level, this would mean theirs (and the employers’) contributions are invested so to pay out the future pension of that individual. DB pension scheme liabilities are valued on an actuarial basis. That is, some very smart math geeks add up lots of numbers on life expectancy to value the cost of paying future pensions.
In an Unfunded scheme, the contributions are used to pay current pensioners. There is no ‘float’. In the case of the NHS Pension Scheme, the Treasury guarantees the scheme’s liabilities. There is no pot of assets lying about. They effectively work on a ‘pay as you go’ basis.
Since April 2015 members of unfunded public sector pension schemes cannot transfer out to Defined Contribution schemes. In effect, this means many doctors are ‘trapped’ in the NHS Pension Scheme.
6. Scheme Pays is ‘expensive’ for doctors
You can pay the Annual Allowance tax charge in one of two ways. You can stump up the cash to HMRC. Or you can get your pension scheme to pay the tax charge for you. This is called Scheme Pays.[10a]
In most DB schemes this works by the scheme paying HMRC. In turn, reducing your future pension according to a set calculation (often called the Commutation Factors). This factor is essentially how many pounds of future pension you give up for a £1 lump sum today. These are calculated by the scheme’s actuaries – updated every so often.
Generally speaking, this means it is financial neutral. You should on average, accounting for time value of money and ignoring the effect of taxes, be no worse off whether you pay HMRC in cash or elect to use Scheme Pays. It comes down to a personal choice: lump sum now, or reduced income in future. That said, as some helpful commenters have pointed out, the Lifetime Allowance is assessed on pension benefits after the deductions for Scheme Pays. So taking Scheme Pays may help to reduce a Lifetime Allowance Tax Charge. However, it is worth being mindful that: (1) your effective tax rate today may be higher than your effective tax rate in retirement; and (2) the future tax rates on pension benefits may change. Whether Scheme Pays pays will highly depend on a person’s financial and tax circumstances.
The NHS Pension Scheme works slightly differently. Instead, the tax charge is paid by the scheme and the payment is effectively considered a ‘loan’ to you. The interest rate on the loan is set at inflation plus 2.8%. When you reach retirement age, the Commutation Factor is applied to the loan, including rolled up interest, to calculate the reduction to your pension.
This creates two issues. First, unlike with many other schemes where the actual impact of Scheme Pays is known at the election, with the NHS Pension Scheme, it can only be estimated. Typically, most schemes will roll forward the cost of scheme pays using a discount rate and then apply the reduction. So this cost of Scheme Pays is known.
Second, this makes Scheme Pays more costly for doctors. This is because unlike most non-NHS Pension Scheme members, they have to pay interest on their Scheme Pays Annual Allowance charge. In addition, when compared to current (March 2019) commercial borrowing, an interest rate of CPI + 2.8% is very high. As mentioned above, most schemes use an assumption for interest rates to calculate the future benefit reduction today. However, I understand (and a helpful actuary in the comments has also noted this) these to be typically around c.5%, though often lower. Increases to keep pensions inline with inflation are applied by the NHS at CPI+1.5%. This means that the cost of Scheme Pays increases faster than the inflationary uplift. Together, these make assessing whether Scheme Pays works out very difficult. It varies significantly person to person and year on year.
Bringing it together
Collectively, this means that there are some unfortunate NHS employees left in an impossible position. Caught, often unintentionally, by the Tapered Annual Allowance. Many do not have the funds to pay the, often substantial, tax charge. Realistically, how many people have the means to pay an unexpected tax bill of tens of thousands of pounds (and as well as income tax)?
A combination of the large tax bills or missing the deadline for Scheme Pays means many doctors facing taking a ‘loan’ at inflated interest rates which eats away at their retirement pension. Some have opted out of the pension scheme. The NHS Pension scheme offers no flexibility to reduce contributions or accrual to avoid this.
We can see that the TPA was designed with anti-avoidance measures in mind. Adjusted Income is £40,000 more than Threshold Income – the same amount as the Annual Allowance. The idea being to snag high earners avoiding tax charges/higher taxes by putting more money into their pension. But it, perhaps unintentionally, set a trap for all the workers who, through no choice of their own, contribute and/or accrue more than the Annual Allowance to their pensions.
Bad tax laws hurt us all
At this point, some might be tempted to whip out their tiny violin. But this misses the point.
Bad tax laws hurt us all. Taxes should be fair. Or perceived to be fair. When they are unfair, they undermine our collective belief in social justice. Just because somebody earns more money, or has a particular profession, does not excuse bad tax policy.
The Tapered Annual Allowance is particularly punitive. This is compounded by poor design. You can get caught by the TPA unwittingly. And when you do, it can be often over a ‘cliff edge’. This has the effect of distorting behaviour in a negative way. For doctors, this has meant many working fewer shifts – thus reducing services for the public – or putting less money away for their retirement. That is a poor outcome for society.
I am glad that doctors are making noise about this. Many financial professionals have been complaining about the TPA for some time (myself included). We have not been able to bring about an end to this ludicrous tax policy. I hope that the voices of our NHS professionals can change that.
Please note, I’m not an FCA authorised financial adviser. This site provides information, comment and opinion for information purposes only and should not be considered financial advice. The site may contain incorrect information or mistakes. You should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any information you do it at your own risk.
All the best,
Young FI Guy
I try my hardest to make all posts as readable and jargon-free as possible. That is an immense challenge when it comes to something as complicated and convoluted as the Tapered Annual Allowance. In many places, I have favoured brevity over being comprehensive. That’s because to not do so would make this post unintelligible. I have indicated where it’s more complicated than that in the post:
 I use the word doctor throughout. But we should be mindful this can apply to other medical and non-medical in the NHS Pension Scheme.
 It’s Threshold Income of £110,000 we care about. See the diagram in the post or this explanation from HMRC: https://www.gov.uk/guidance/pension-schemes-work-out-your-tapered-annual-allowance#threshold
 What is and isn’t Pensionable Pay is quite complicated. The NHS defines Pensionable Pay as: “the basic salary excluding overtime (in excess of whole time hours), one off bonuses and expenses. Pensionable pay should however include regular payments such as unsocial hours allowance and London weighting.” (https://www.nhsbsa.nhs.uk/sites/default/files/2018-02/Employers%20quick%20start%20guide%20to%20the%20NHS%20Pension%20Scheme-20180222-%28V2%29.pdf)
 This also affects employees in the financial services sector who may have large discretionary bonuses (as a proportion of income), usually towards the end of the tax year.
 That’s not universal, but things such as discretionary bonuses, salary increases, one-off emoluments may occur during the year and change the amount and rate of accrual into a DB pension.
 For DC pensions this is calculated as:
For DB pensions this is calculated as:
Where ‘value’ is equal to pension income multiplied by a factor of 16. Note that if the difference is a negative amount then your pension input for the arrangement is nil.
 Individuals don’t have a ‘claim’ on specific assets of a pension scheme, there is no such distinction. That said, some mental gymnastics are used when, for example, a member transfers out from a DB to a DC scheme.
 There are loads of different valuation ‘bases’.
 Although it’s potentially possible to transfer to other Defined Benefit schemes. See Money Advice Service: https://www.moneyadviceservice.org.uk/en/articles/defined-benefit-schemes
 You have to meet a number of conditions to be able to use Scheme Pays. See this guide from Royal London: https://adviser.royallondon.com/technical-central/pensions/contributions-and-tax-relief/scheme-pays/ For the NHS Pension Scheme see this guide: https://www.nhsbsa.nhs.uk/member-hub/annual-allowance
[10a] One of the conditions is that you must elect by 31 July in the year following the end of the tax year – so for the 2018/19 tax year this is 31 July 2020. This means that many people who are unaware that they are to be hit with a tax charge cannot then use Scheme Pays to pay the bill. Instead having to pay HMRC through Self-Assessment.
 NHS Business Services Authority: https://www.nhsbsa.nhs.uk/sites/default/files/2018-12/Scheme%20Pays-Election%20Guide-20181217-%28V1%29.pdf
 Pension Schemes aren’t set up to ‘loan’ money to members and aren’t allowed to loan money to members. See HMRC Tax Manual: https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm123300 I’m not sure of the exact legal slight of hand the NHS Pension Scheme uses around this.
 NHS Business Services Authority: https://www.nhsbsa.nhs.uk/sites/default/files/2018-12/Scheme%20Pays-Election%20Guide-20181217-%28V1%29.pdf
 I’m explicitly talking about where someone is below Threshold Income (£110,000) but above Adjusted Income (£150,000) and an increase in earnings moves them marginally above the Threshold causing a big TPA tax charge.
 For example, from Citywire in 2017: https://citywire.co.uk/new-model-adviser/news/how-ifas-deal-with-the-ludicrous-annual-allowance-taper/a1008148
[Edited 28/03/2019: corrected error regarding the deadline for scheme pays – you must elect by 31 July in the year following the end of the tax year; corrected error in DB input diagram and added note explaining negative DB pension input is zeroed.]
[Edited 31/03/2019: following some helpful comments I’ve added a bit more on Scheme Pays (in italics). Hopefully, it’s still all digestible!]