If salary increases reduce your pay!

what can you do about it?

take home more income

Imagine how you’d feel if your take-home pay didn’t rise (or it fell!) after a pay increase 🙁

Well, this chart shows that this is exactly what could happen for many civil servants.

Civil Servant Take Home Pay

… and it was shown to me (by a Doctor) as the reason why some Doctors might turn down extra work or leave the NHS pension scheme.

The question is …. is it a useful chart to base such enormous decisions upon?

Well, the chart is taken from the government’s latest (September 2018) Annual Report on Senior Salaries which focuses on senior civil servants, senior police and senior armed forces officers.

So, it’s not really useful for Doctors 

Indeed, as I understand it – the overall benefit (pay and pension) accrual situation for Doctors can be quite dire where a good proportion of their pay comes from overtime on which no extra pension benefits get earned.

In some cases, such overtime earnings can push their total earnings into the band where they start losing their annual pensions input allowance. This can mean penal pensions input taxes and that can result in total marginal tax rates of more than 100% without any pension benefit in lieu. 

So, clearly, a solution is required to remove the disincentive for Doctors to work overtime.

There may (in some cases) be ways to mitigate this tax (for example by paying money into a personal pension to reduce taxable income (before pension contributions) below £110,000 (a figure known as ‘Threshold’ income in pensions parlance) as this will prevent the ‘tapering’ of the pensions input allowance. 

But, as you can see already, this is all very technical and the solution won’t help everyone. So, case by case advice from a good pensions specialist would be required. 

The golden rule in this, as in most matters of financial planning applies …

Shaw. The Golden Rule

That said …

.. the more general issue of flat or falling take-home pay (as gross salary increases) for civil servants (and Doctors) where all their pay counts towards pensions is a bit different.

And, whilst it’s easy to see why people might not want to strive for higher incomes when they see little or none of that increase in their pockets … this chart, like many simple charts on pension matters … gives a misleading picture.

So, let’s get to the facts

The chart is provocative because it shows that the take-home pay of highly paid civil servants, on salaries between around £100,000 and £170,000, remains broadly flat whilst their gross pay goes up.

And the reason for this is twofold:

First, all UK taxpaying high earners start to lose their ‘ tax-free’ personal allowance as their income goes above £100,000. And they lose all of this allowance on earnings of £123,700 or above – resulting in an ‘effective’ marginal tax rate (in this band of earnings) of 60%.

Second, these highly paid civil servants (and a few others, lucky enough to still be accruing defined benefit pensions in the private sector) suffer an additional income tax charge when their pension input* goes above their pensions annual allowance.

This chart assumes that they have to pay that tax charge out of their own pocket – which they don’t as we’ll see in a moment.

* The pension input is the amount the member pays in plus the amount deemed paid into their pension scheme by their employer.

In defined benefit (DB) pension schemes this amount has to be calculated using a special formula because there is no identifiable ‘pot’ of money (or contribution rate) for each individual.

Indeed, in many public sector schemes, there isn’t even a pension fund. Pensions are simply paid out of future general taxation.

So, this chart only focusses on the take-home pay issue. It does not show the value of the extra pension that these civil servants will accrue.

And, clearly, they need to understand the benefits as well as the costs of their financial options if they’re to make informed decisions …  about doing more work, going for a promotion or leaving the pension scheme altogether.

No one should decide on such matters with only one side of a complex argument.

So how valuable ARE the increased pension benefits for people in this group?

Well, let’s take an example of Sam, a senior civil servant who:

• Is a member of the ‘Premium’ (final salary (FS)) defined benefit (DB) pension scheme**

• Accrues a 60th of Final Salary as pension for each year of service

• Already has 20 years’ service in the scheme (giving an accrued a pension of 1/3 (20/60) of FS) and

• Gets a big promotion which takes his / her salary (net of personal contributions to the pension scheme) from £96,000 to £110,000 a year.

** To keep this simple I’ve chosen a final salary type of DB scheme as an example.

The pension input calculations are more complicated for the more recently introduced career average revalued earnings (CARE) types of DB pension.

So, take care to get your sums right if you’re in one of those schemes.

Now, we can already guess, using the chart, that Sam’s take-home pay might not rise despite this massive pay increase.

What might surprise you is that his income could even fall – and by quite a lot – in this example (see below) due to the fact that Sam’s large pay increase falls largely in the ‘double whammy’ tax zone.

But for now, we want to know how much has Sam’s pension fund has ‘effectively’ grown. And to work this out we need to look at Sam’s pension benefits before and after his promotion.

Before his pay increase, Sam had accrued a pension of £32,000 p.a. (£96,000 x 20/60)

Then, a year later, with his pay increase, he’d have accrued a pension of £38,500 p.a. (£110,000 x 21/60)

So, that’s an increased pension entitlement of £6,500 p.a. simply due to his pay rise and one year’s extra service.

OK, but that’s not much … why do the tax bills wipe out pay increases?

Well, actually this pension increase is worth a lot … and if you wanted to generate that extra £6,500 p.a. guaranteed pension yourself using a private (personal) pension, you’d need a fund of around £210,000

(This assumes today’s inflation-linked annuity rates)

Of course, if you had plenty of time (say 20 years) to build such a fund in today’s money terms by your retirement age, the amount you’d need to invest today might be nearer £100,000. But you’d have to invest your money into the markets to have any chance of getting that sort of investment growth.

And if that didn’t suit your attitude to (or capacity for) investment risk, then you’d need to invest something nearer the full £210,000 target fund to generate the extra income that Sam will enjoy because of his pay rise.

For Sam, the civil service guarantees his future pension (as a % of final earnings in this case) and he does not need to worry about investment issues.

So, Sam’s pay rise is incredibly valuable

The trouble for Sam is that the taxman (HMRC) limits the amount of these pension ‘inputs’ on which they give tax relief. And they tax you personally, to wipe out your tax relief, if your ‘input’  (including inputs from your employer) exceeds their limit.

In Sam’s case, HMRC will likely value this substantial increase to his pension benefits as an ‘input’ of around £100,000.

For those interested, they calculate the input as 16 times the inflation-adjusted increase in the pension year on year. So, that’s just a bit less than 16 times £6,500 p.a.

And their (normal) pension input limit (or ‘annual allowance’) before tax charges bite is currently £40,000.***

So, Sam will be liable to further income tax charges (at his marginal rate) on the £60,000 (£100,000 -£40,000) excess pension input.

*** to keep this simple I’ve assumed that Sam has used up all his annual pension input allowances in the previous 3 years due to other big pay increases.

If that’s not the case he might be able to carry forward some unused pension allowances from 3 previous years to reduce his tax bill.

Sam’s caught in a double whammy of taxes

Of course, this pension input tax charge is in addition to Sam’s c.60% marginal rate income tax charge on most of his pay rise this year (the part above £100,000 – see earlier)

And to avoid boring you with the grisly calculations … I can tell you that this could give Sam an extra tax bill (created by this simple £14,000 pay increase) of nearly £35,000!

Yes, that’s right … £35,000 … which means, if he paid it, his net income would fall substantially as a result.

What do I mean,  “if he paid it”?

Surely, I’m not suggesting he evade tax?

No, of course not but whatever you think of HMRC, they’re not stupid. They saw this crazy tax problem coming a long time ago.

And they made rules to allow large pension input tax bills to be paid out of your pension scheme so that you do NOT have to take a pay cut!

And that’s another reason not to use that chart above to make decisions. It assumes you will pay the tax bill out of your own pocket!

Instead, if it’s right for you (with your particular personal circumstances – not Sam’s!) to continue paying into your pension scheme, you might want to consider applying for the (creatively termed) arrangement called, ‘Scheme Pays’ … and allow your tax bill to come out of your nicely enlarged pension fund.

Why is this so complicated?

Well, it certainly is complicated but please don’t shoot the piano player for that.

Better to write to your local MP and ask them how the government managed to introduce swathes of new regulations to ‘simplify’ pensions (on ‘A’ day in April 2006) to arrive at this mess.

In the meantime, if this issue affects you and you’d like to have more take-home pay when your income goes up, ask your pension scheme administrator for details of how the ‘scheme pays’ arrangement could work for you – and what fees (or loan interest rates) would be charged.

It might sound horrendously painful to incur a large additional tax bill (on your pension input)  of around £24,000 (as in Sam’s extreme case) and be considering paying loan interest on that bill too but …

… if that means you get to enjoy an effective extra pension fund in retirement of c. £210,000 it might just be worth it eh? 😉

OK, so, is there anything else to worry about?

Well yes, I’m afraid so …

You see, when the government messed with ‘simplified’ pensions in 2006, they didn’t just put an ‘annual’ limit on the ‘input’ amounts that could be paid into your pension before you start suffering tax …

… they also added a ‘lifetime’ limit on the fund (or equivalent fund) you can accrue in pensions by the time you take benefits.

And if your total pension fund is deemed to be worth more than the ‘lifetime’ limit (currently £1.03 million) then you could pay extra tax on the income (or cash) you take out from that excess element too.

What’s more, the government haven’t stopped ‘messing’ with pension rules since they issued their simplified 😉 new book back in 2006.

So, the annual input allowance (£40,000 in Sam’s example):

  1. Tends to get changed for everyone from time to time when the government fancies it.
  2. Will be reduced for you personally – and drastically down to just £4,000 – if you start to draw benefits (other than by annuity) from any pension arrangement and
  3. Will be reduced on a tapered scale (down to £10,000) if your earnings (including the value of these pension benefits) are between £150,000 and £210,000.

And there are other tripwires to avoid also …

The bottom lines

The tax challenges for high earners around pension input (and lifetime) allowances apply to both defined benefit (DB) and defined contribution (DC) pension schemes.

I’ve simply focused on DB schemes here – because this is where some particularly poor thinking amongst professionals  – appears to be going on.

Clearly, the rules around pensions in the UK are not simple … and are even less simple, since governments tried to simplify them in 2006!

All higher earners in pension schemes should consider the net benefits (after all taxes**** and under various life scenarios) of continuing to make pension contributions or continuing with scheme membership.

****We’ve not yet talked about the Inheritance Tax (IHT) mitigation benefits of pension saving – but they’re most certainly worth taking into account if this issue affects you or is likely to in the future.

Registered pensions schemes are very efficient IHT planning investment vehicles – unlike those ‘so-called’ Tax-Free ISA accounts which could lose 40% of their entire value (yes, 40% of the whole value, not just the growth) through IHT, if your other taxable assets are in excess of your nil rate bands

And as Michael Caine might have said …

‘not many people realise that’   

So, just looking at take-home pay charts – like the one above – tells you nothing useful about what to do with your pension.

The calculations of long-term costs vs benefits to you personally – and the planning required to avoid unnecessary tax – are complex. And this is especially true for those in public service (and for the few in private sector DB pensions schemes).

So, be sure to take good quality financial planning advice.

And, if these issues affect you or your family, you can almost certainly afford to take that good advice.

Indeed, you might even find that you could be tens of thousands of pounds better off if you get your personal financial planning right in this area.

Oh, and in case you’re wondering … No, this is not a pitch for my services.

My work is all about general financial education and coaching.

For this issue, you really do need to talk to a specialist pensions/tax adviser.

But I hope this has helped

All the best for now

Paul

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