Corrected contributions? Understanding the NHS pensions tax ‘trap’

Every year that goes by, winter in the NHS gets tougher. This year, the normal operational pressures have been exacerbated by the increasing impact of discontent from doctors and senior managers affected by pension tax penalties, and NHS England and Improvement are extremely worried by the situation.

Pensions taxation is complicated, and not a subject on which we claim to be experts here at the Nuffield Trust. But in essence, in recent years the amount of pension savings that an individual can accrue free of tax each year (the ‘annual allowance’) has reduced significantly, particularly for high earners. In addition, there is a ‘cliff edge’ effect, where earnings crossing a threshold by even a small amount can increase the marginal taxation very significantly.

Where doctors undertake additional shifts, it can be very difficult to predict the effect on their tax position in advance of the year end. As a result, many doctors are now reducing their hours and refusing to work additional sessions – not because they are reluctant to pay tax in normal circumstances, but because the impact of the annual allowance taper and cliff edge may be that they are effectively paying to come to work.

Consequently – in a measure announced not through the normal channels but via the Times newspaper – NHS England, the Department of Health and Social Care, and the Treasury have come to an agreement that the tax bills incurred by doctors on their pension contributions above the normal allowances would be funded by the government. Subsequent guidance explains that doctors and other clinicians should make use of ‘Scheme Pays’, where the tax bill is paid via the pension scheme, which normally results in a reduced pension for the individual. The guidance states that there will be a ‘contractually binding commitment’ to make the ‘hole’ in an individual’s pension pot good in future years, so that his or her pension would be unaffected.

But the absence of a formal announcement still leaves many questions unanswered.

How will this proposal avoid doctors being taxed unreasonably?

For individuals caught by the pensions tax ‘trap’, the employer’s contribution is included when assessing the tax due – so it would appear that without changes to HMRC rules, the making good of the hole in a future year would simply result in increased tax for the individual in that future year. NHS England appear to be seeking to avoid this by committing to pay “ongoing annual payments in retirement” – effectively an additional payment alongside the individual’s pension, rather than by actually topping up the pension pot itself. The fine detail of how this will work in practice is yet to be established, and an exchange of letters seen by the Financial Times shows how much the normal rules are being bent to make this fix work.

However, the guidance is clear that this is a temporary fix applying to 2019/20 only. Some doctors have already had to remortgage their homes to pay tax bills for the financial years 2017/18 and 2018/19, and are understandably asking whether they will be compensated retrospectively.

Why not take the same approach for all staff on the NHS Pension Scheme?

The guidance is explicit that it applies only to clinicians – that is, nurses and allied health professionals as well as doctors. But many senior managers are also affected by huge tax bills relating to their pension. The incoming CEO of University Hospitals Birmingham said recently that he was effectively paying to come to work for his first year. NHS England claims that “there is a less clear case that annual allowance tax charges are creating similar retention and productivity issues in the non-clinical NHS workforce.” Many doctors themselves have said that any solution which only addresses one group of staff is divisive and unfair.

How much will this cost the NHS?

It is difficult, if not impossible, to calculate the financial impact of this proposal. Tax calculations are personal to each individual. The calculation of the annual allowance taper takes into account income from all sources, so it is difficult to see how calculations to disaggregate other income from NHS-based income could be done in practice. The BMA estimates that over 30% of consultants have received an annual allowance tax charge over the last two years. With over 51,000 consultants employed in England, if a third of those people received an average bill of just £20,000 the cost would be over £300 million. Many consultants have received bills of well over £50,000, and some are being billed in excess of their annual salary, so this figure could be a significant understatement.

Will this affect the affordability and sustainability of the NHS Pension Scheme?  

NHS England have stated that these costs will be met centrally, not by individual employers. The NHS Pension Scheme is a ‘pay as you go’ scheme: pension contributions made by individuals and their employers are essentially paid into the Treasury, which then provides the funding required to pay current pensions via the NHS Business Services Authority. The source of funding for the ‘top-ups’ proposed to doctors’ pension pots is not clear, although the implication of the report is that the Treasury has agreed to provide funds. The annual cost of the NHS Pension Scheme showing in the DHSC accounts for 2018/19 was £5.2 billion, and the most recent actuarial valuation of the NHS pension scheme showed aggregate liabilities of some £298 billion. Arguably, therefore, the additional contributions required by this one-year ‘fix’ are relatively small in the context of the liabilities of the scheme as a whole – even if the hypothetical figure above is an understatement. But if there are no changes to the overarching tax regime and a similar fix is required year on year, the costs could mount up quickly.   

The government and NHS England clearly hope that the proposal trailed last week will be sufficient to prevent a catastrophic reduction in the availability of the medical workforce at the most pressured time of year for the NHS. But it would appear that doctors are looking for answers to their many questions before they quietly return to work. Indeed, many may decide that a reduction in their income is a price worth paying for a better work-life balance. Time will tell whether NHS England have provided sufficient reassurance to doctors to avoid the worst.