Millions of public sector workers will be seriously short-changed by the government when they retire unless they take action well in advance. But most of them will never know about it.
This is why I hate pension legislation - it has made things so complicated that few people ever work out what is really going on. And the government is using exactly this kind of black-box trickery to cut the amounts it has to pay to public sector workers when they retire.
Under the pension scheme rules, you’re allowed to take up to a quarter of the value of your pension fund as tax-free cash. That sounds simple, but lo and behold, when it comes to ‘final salary’ schemes like those for public sector workers including teachers and civil servants, it’s not that simple.
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Final salary pension holders are vulnerable
With people like me, who just have ‘money purchase’ pension plans, it’s easy: I can take a quarter of the value of my fund as tax-free cash. My fund is invested in shares and unit trusts, so it’s easy to work out its value. But what is the value of your fund if you’re in a final salary scheme? There are two possible answers to that:
• The value of your fund is what it would cost you to buy in the market the annual pension benefits the scheme has promised you
• The value of your fund is what the government says it’s worth.
No surprises for guessing that the government has chosen the second answer, and that this method costs it a lot less.
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You give up very expensive protection
The easiest way I can explain this is to ask: what would it cost you to buy £1,000 of pension income (before tax) on the same terms as you get from the civil service pension scheme at age 65?
The answer is about £20,000, which may strike you as a lot of money to provide that income, but the point is that your pension is index-linked for life and whatever happens to the cost of living over the next 20 or 30 years, you are protected from this.
That protection is very, very expensive to buy in the marketplace - so expensive, in fact, that almost nobody retiring in a private sector scheme actually buys an index-linked pension annuity.
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Playing straight with people
So one answer to the question: ‘How much tax-free cash you should get when you retire from a final salary scheme?’ is ‘About £20 (depending on age and sex) for every £1 of pension income you forego.’
In fact, the civil service scheme offers just £12 per £1 of income, which assumes you could get a return of 8% on your money - but you can’t, not on anything like the same terms. In other words, you’re being cheated.
Some may argue that given the gold-plated benefits that civil servants get from final salary schemes, it’s only fair they should be cut back a bit, and personally, I think there’s some merit in that argument, but I see no merit and a lot of disgrace in doing people down by sleight-of-hand and hard-to-understand financial trickery.
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Taking the lump sum early can be an even bigger rip-off
Now the government isn’t alone in cheating pension scheme members in this way. Most final salary schemes offer conversion rates well below the marketplace reality.
In addition to devaluing their benefits in this way, some private sector schemes have taken to offering people cash lump sums in order to persuade them to leave the final salary scheme and take a lump sum ‘transfer value’ to a money purchase scheme, thus giving up their guaranteed pension rights and taking on all the investment risk themselves.
This can be a huge rip-off and unless you think seriously about it you’ll never realise how much money is at stake. This sort of deal is likely to cost someone earning £20-30,000 a year £50,000 or more.
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How to beat the system
There is a way to beat the system, though. Most final salary schemes offer members an ‘Additional Voluntary Contribution’ plan into which they can put their own extra contributions. These get tax relief so that a £100 monthly contribution will actually cost a basic rate taxpayer a net £80.
At retirement, many final salary schemes allow members to take their tax-free cash entitlement from their AVC pot. That means they don’t have to give up any of those valuable index-linked benefits or accept lousy terms for converting pension rights into tax-free cash.
Suppose Tony had saved £100 a month (costing him £80 net) into an AVC for the past 15 years and after an average growth rate of 7.5% his fund was now worth £33,000 at age 65 when he’s retiring. Suppose that this £33,000 exactly equals his tax-free cash entitlement at £12-to-£1.
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The sums don’t add up for Tony
So instead of Tony giving up £2,750 of his index-linked pension to get £33,000 tax-free cash from the main scheme, he simply draws £33,000 from his AVC and keeps his full pension entitlement.
Numerous studies in the US have shown that the maximum rate at which you can draw an income from capital and be sure you don’t run out of capital at any time in the following 30 years is 4%. On that 4% basis, £33,000 produces an annual income of just £1,320, and without any guarantees.
The difference between that and a guaranteed index-linked £2,750 is £1,430 a year, and Tony would need over £25,000 to generate £1,430 with the same guarantees he gets with his civil service pension.
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That’s how much Tony has benefited from saving up in order to draw tax-free cash from his AVC - in other words, the benefit from retaining his full pension has added £25,000 to the return from the AVC scheme, which means he’s nearly doubled the return on his money.
So if you are in a final salary scheme, check the rules to see if you can take all your tax-free cash via the AVC, and if you can, start saving in this way.
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And another con is on the way
What you and I should be asking the politicians is why we have to have such a complicated and messy system. Amazingly, the politicians and civil servants just don’t get it.
They think we should trust them and that complexity doesn’t really matter. They are wrong. Complexity does matter. People don’t trust things they don’t understand, least of all when - as with pensions - the government has tinkered again and again with the rules, most of the time to our disadvantage.
They did it again last month. The government brought forward by three years to 2009 the date at which S2P (the top-up to the State pension) will convert from an earnings-related to a flat-rate basis.
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Stealth taxes everywhere and precious little to show for them
That sounds pretty harmless, but it means that anyone earning over the upper level of entitlement to S2P (£30,000) will still pay earnings-related NI contributions (on earnings up to £40,000) into the scheme for which they will never get any benefit. This amounts to a stealth tax of several hundred pounds a year for anyone earning over £30,000 a year.
Why has the government done this? It looks like it’s to generate a few hundred million pounds more to help fill the hole in the public finances. It’s certainly not a policy it’s proud of or keen to explain, since you won’t find out anything about it from the HMR&C, Department of Work & Pensions or Treasury websites.
But you could try asking your MP why you’re being forced to pay more tax in this way.
