This post builds on our existing NHS Pension series. Throughout the post we’ve put links, where relevant, to the appropriate prior material. We do, however, suggest refreshing your understanding of the NHS Pension prior to reading on.
One method of saving money for retirement is to use a Self-Invested Personal Pension (SIPP). How does a SIPP fare when compared to the NHS Pension? What are the pearls and pitfalls of using both together?
Head to head
Direct comparison of the NHS Pension and a SIPP is a relative ‘apples versus oranges’ affair, on account of their different styles (defined benefit vs defined contribution). Assuming equal pension contributions, you’d need consistently strong returns (5-6% real returns) on your SIPP’s investments to match the retirement income that’d be provided by an NHS Pension*.
Although the SIPP’s pension pot might compound up to a large amount, you will have to subtract from said pot to provide an income. If you wanted to retire early, your pot would have to be even bigger to afford you an equivalent longer lasting income. The NHS Pension, by comparison, has no pot and will provide you with a consistent retirement income for as long as you live. In sporting terms, the NHS Pension is the marathon runner. It has great stamina and just keeps the same pace up mile-on-mile. By comparison the SIPP is more like a middle-distance runner. It has reasonable stamina so can keep up for a while, but eventually it’ll fade as the NHS Pension continues to jog along.
There are scenarios where you may want to totally eschew the NHS Pension and plump solely for a SIPP. For example, if you see your long-term employment outwith the NHS you may consider using a SIPP instead of having to later transfer your NHS Pension§. It’s unlikely, however, that you’re weighing up the choice between the two and instead are considering contributing to both.
SIPP and NHS Pension
The Taxman Giveth
Pensions are powerful tools to moderate income tax, especially so for those in the higher (40%) tax bracket. This is best shown with an example.
Dr. Danielle is earning £60,000/year. In addition to her NHS Pension, she decides to contribute to a SIPP. She contributes £4,800 to a SIPP. The government will add 20% basic tax rate relief, which takes the total pension contribution to £6,000☨.
Dr. Danielle is in the higher rate tax bracket, so she claims a further 20% tax relief and receives £1,200 back from HMRC. As such, the overall cost to Dr. Danielle of her £6,000 pension contribution is only £3,600!
Hopefully you can see how significant the tax benefit is. Although pension contributions are tax-free on the ‘way in’ to a SIPP, you will be taxed on that money on the ‘way out’ i.e. when you start drawing a pension. That doesn’t mean you can’t make overall savings though:
Dr. Danielle has now retired and is drawing a pension from her SIPP. She is withdrawing £50,000/year in pension income. This is subject to income tax. She pays no tax on the first £12,500 (personal allowance) and 20% on the next £37,500 (basic rate).
Therefore Dr. Danielle got 40% tax relief on her pension contributions (example 1a) but is now only paying 20% tax on her pension withdrawal – an overall saving of 20%.
You may end up paying the same income tax on your pension as you got in tax relief initially (e.g. 40% tax relief on way in, 40% income tax on way out). There is still gain to be had though – that money has been invested and hopefully significantly increased in value in the intervening period. Contributing to a SIPP in addition to the NHS Pension may help reduce your current tax burden and possibly your future one too.
The NHS Pension is a relatively inflexible beast, although it does have some bells and whistles when it comes to buying more pension. By comparison, using a SIPP will enable you to exert more control over your pension strategy.
There are a plethora of providers and with them a broad range of investment choices. Various industry big hitters offer SIPP’s, stocks & shares ISA’s and general investment accounts. This allows you to have a one-stop-shop for your private pension and investing needs❡. Should you want to stick to one investing strategy, you could hold the same investments in three separate accounts; the tax-deferred but inaccessible SIPP, the tax-free relatively accessible ISA and the taxable, accessible GIA.
Arguably the most punitive aspect of the NHS Pension is the reductions for claiming your pension prior to your State Retirement Age (SRA). These are hefty. For example, it’s a 45% reduction in pension income for claiming ten years early. A SIPP, however, can be accessed up to ten years before your SRA without penalty. Should you wish to retire early, you could use a SIPP as an income ‘bridge’ for the decade leading up to your SRA. This will allow you to leave your NHS Pension untouched and therefore unpenalised.
Relying on the NHS Pension scheme for your retirement income is an ‘eggs in one basket’ approach. It’s possibly a matter of when, not if, meddling politicians will prune the NHS Pension tree again in the future. There have been iterations of the scheme in 1995, 2008 and 2015. If the trend continues we might expect another repackaging within the next decade. Although we can only speculate, it seems unlikely that it’d be more generous than the existing scheme.
Using a SIPP might help reduce your ‘pension interference risk’, making you less vulnerable to future reforms. We should note that SIPP’s aren’t immune to future fiscal policy changes either, though it’d perhaps be unlucky for both SIPP’s and the NHS Pension to suffer significant detriment in tandem. A diversified approach is good for income streams and investment strategies, why not retirement strategies too?
The Taxman Taketh Away
The biggest throttle on any SIPP contributions are the Annual and Lifetime Allowances. I covered these pension tax thresholds in relation to the NHS Pension in a previous post.
It’s possible to calculate how much Annual Allowance (AA) remains after your NHS Pension contributions each tax year. To avoid incurring a tax bill it’s a simple matter of avoiding contributions to your SIPP that push you over the AA. In this regard ensuring your maths is correct is vital, as well as being aware of other pitfalls such as AA tapering. It’s possible (/probable) there’ll come a time where you breach the AA with your NHS Pension alone, thus rendering any SIPP contributions taxable.
Dr. Dinesh earns £42,000/year and wants to contribute to a SIPP, but is wary of the annual allowance. He uses his Total Reward Statement to work out how much NHS Pension he’s already accrued.
From this he can calculate the opening value (say £8,000) and closing value (say £18,000) of his pension for the year. That makes his pension input amount £10,000 for this year. As the AA is £40,000/year, Dr. Dinesh can contribute up to £30,000 to his SIPP.
Dr. Dinesh contributes £2,400 to his SIPP. He gets 20% basic tax relief on this☨, which takes the total pension contribution to £3,000.
As his total pension contribution is £13,000, Dr. Dinesh has not breached the AA.
Determining whether you’ll breach the Lifetime Allowance (LTA) with your NHS Pension is difficult. Both LTA and NHS Pension growth are linked to inflation, while the latter also accrues based on your salary. It’s therefore probable one will breach the LTA, but not necessarily certain*. Contributing to a SIPP as well will increase the likelihood of accruing a pension whose value exceeds the LTA. It’ll also bring about an LTA breach more quickly.
There may well come a time when you’ll need to decide whether the benefits you derive from contributing to a SIPP outweigh the tax bill for breaching either of the two pension allowances. Retiring early, or a cessation/reduction in pension contributions, may mitigate against or even negate this issue. There are numerous factors involved here, including the timing of claiming your pension. Optimising this timing, and the impact of these benefit crystallisation events, falls outside the purview of this post.
At What Cost?
Membership of the 2015 NHS Pension scheme costs a set percentage of your salary each year. In return you get a revaluation process that provides a guaranteed real (i.e. after inflation) growth of 1.5%. This is not to be sniffed at – a consistent, assured, compounding machine.
SIPP’s have membership costs too. Typically this involves an annual ‘platform’ fee and possibly also charges for buying shares. If fees total 1% of the value of your pension pot, you’ll consequently need returns of 1% on your investments just to break even. You’ll have to consider the effect of inflation too (which could be any number, but let’s say for example it’ll be in the region of 2%). Already you’ll have to make a 3% return on your investments just to stop real-term devaluation of your SIPP. This is not insignificant – the returns on the investments you hold in your SIPP are far from certain. Historical investment data would suggest that over a long enough period of time you’ll come out on top, but this is not guaranteed.
To mitigate the effect of fees you can use the cheapest SIPP that meets your requirements❡. Employing an investment strategy that maximises returns in accordance with your risk appetite and tolerance will hopefully ensure your investments outgrow inflation and then some.
A minor, but non-zero, cost of using a SIPP is a temporal one. Calculating your remaining annual allowance, managing the account, tracking performance, claiming tax back from HMRC. These cost time; the faff factor may be off-putting for some.
The sweet spot: a theoretical pension strategy that will:
• require minimal effort to set up and maintain
• maximise the tax relief earned from pension contributions
• reduce future pension interference risk
• minimise the cost of a pension
• increase in value in real terms i.e. grow faster than inflation
• facilitate unpenalised drawing of pension income before SRA
• avoid breaching either annual or lifetime allowance
Crystal Ball Gazing
There are too many personal, professional and financial variables for us to suggest a ‘one size fits all’ winning pensions strategy. For each individual there’ll be a strategy that’s in the sweet spot, optimised for their particular plans. It’s equally impossible to predict how future governments will enact NHS and fiscal policy and its consequent effect on our pension(s). All we can do is plan for the future using what we know today and avoid over-speculating.
I hope that this chapter in our NHS Pension series has given you some factors to consider as you decide whether a SIPP is an appropriate accompaniment for your NHS Pension.
*I’ve made a significant number of assumptions when doing these calculations – many of them pertain to my own circumstances, which may not necessarily reflect yours. You should do your own research in this regard. As ever, the material in our disclaimer applies.
☨Basic-rate tax relief (20%) is claimed at source by your SIPP provider who receives this directly on your behalf from HMRC. Tax brackets current as of 2020/21 tax year.