Opting out of the NHS Pension

A question that I see cropping up with relative frequency, and often from new doctors, is whether one should eschew the NHS Pension altogether.

On reflection, the NHS Pension series is predicated on an assumption: that you’re sticking with the NHS Pension. It’s easy to be dismissive of those who would consider leaving the pension scheme, but I think it’s important to discuss the pros (for there may be some) and cons of doing so. Let’s flip the narrative around: why might one opt out of the NHS Pension?

I’ve made a host of assumptions while writing this article. They are unlikely to all apply to your personal situation. I’ll put the base assumptions in a footnote and mention where I’ve deviated from them. As ever, please read the disclaimer and seek professional, independent financial advice for recommendations tailored to your individual circumstances.

A bit dear

You might want to opt out of the NHS Pension because you can’t afford it.

The cost of being a member of the NHS Pension, as a percentage of your pensionable pay, rises during your career:
→ 9.3% [from F1 up to CT/ST2]
→ 12.5% [during CT/ST3 – 8]
→ 13.5%+ [as a Consultant]
As both pay increases and contribution percentage rises, the cost of the NHS Pension increases non-linearly. It’s far from a negligible amount:

Monthly cost of NHS Pension scheme membership by training grade. In your first year of work as a doctor you can expect to pay £2,679 (∽£220/month) towards your pension.

Perhaps you have a mountain of (non-student) debt that you’re keen to eradicate ASAP. The UKPF flowchart, many people’s go-to algorithm for personal finance, suggests that you’re making the minimum payments on all debts and clearing debt with a >10% interest rate before auto-enrolling in your workplace pension.

Perhaps you’re the solo earner in a household and need the extra income to make ends meet. The list of reasons could be endless. For some people that money may be better placed in their pocket rather than their pension.

You might decide to opt out of the pension but then subscribe to it later on when you’re on a more even financial keel. In support of this you could point to the fact that, in terms of benefit, the early years of the NHS Pension don’t count as much.

You’d be correct; the benefit to you in retirement of your F1 pension year is approximately £2,250/yr each and every year until you die. Income for life! For F2 it’s £2,500/yr. That’s lesser than the value of, say, an ST3 year (£3,400/yr) or the first Consultant year (£4,500/yr).

Invaluable

That’s only half the story, however, for the pension you accrue earlier in your career is the cheapest, i.e. the best value for money. The cost of each £1 of pension accrued in your F1 year is 5p. That’s cheaper than your ST3 year (7p), first consultant year (10p) or any other year for that matter.

The value to you in retirement of every £1 cost spent on the NHS Pension during your training. As you can see, the early years’ cost provides the most value-for-money, even if the absolute value is not as high as some of the latter years.

Described the other way around, you’ll receive £21 of retirement income from every £1 cost of the NHS Pension in F1. Much better than from your ST3 (£14) or first consultant year (£10). That’s a lot more ‘bang for your buck’, so consider carefully whether you want to miss out on such value.

Anything you can do, I can do better

You might want to opt out of the NHS Pension because you feel you can earn better returns on your money elsewhere. I would say this is the most common argument I see against the NHS Pension.

Your NHS Pension doesn’t grow per se, but your pension benefits are revalued annually to the tune of 1.5% + treasury orders (≈ inflation). You perhaps feel that you might achieve more than this guaranteed, real-terms, 1.5% growth. To make comparisons, I’m going to use three fictional individuals:

  1. Zippy, the pensions naysayer. They believe that they can beat the growth of the NHS Pension and that pension tax benefits are overrated. They use ISA’s to invest their money instead. For completeness, I’ll model Zippy’s portfolio using
    a) just a Lifetime ISA [LISA]
    b) just a S&S ISA
    c) a combined approach using both.
  2. Sippy, who decides they can earn greater returns elsewhere, but recognises the tax benefits of pensions. They take the money they would have been paying to be an NHS Pension member and put in a self-invested private pension (SIPP).
  3. Nippy, who simply opts in to the NHS Pension in its most basic form, i.e. without buying extra pension or any other frills.

Value of pension ‘pot’ at retirement

The capital (‘pot’) value of the different pension strategies. The NHS Pension’s capital value at state pension age is nearly double that of the next best strategy. I know you’re wondering why the blue line only starts 2/3rds of the way along the graph. This is because the NHS Pension suffers actuarial reductions if it is taken early, which will consequently reduce its capital value. For comparable modelling, it makes most sense to take this into account.

Zippy’s LISA strategy is a bit of a bust. The limit on contributions (£4,000/yr) and not being able to contribute after 50yrs old provides them a LISA value of £590,000 at state pension age. The S&S ISA strategy is a bit more promising, owing to greater contributions for longer – value of their S&S ISA ends up at £1.2m. The joint strategy is the non-pension winner, however, as the combined effect brings Zippy’s best effort to a pot of £1.4m. (I’ll use this strategy in any calculations going forward.)

Sippy’s strategy benefits from their contributions being tax-free and being able to contribute all the way up until retirement. Their private pension has compounded over time, giving them a £1.5m pot, 14% more than Zippy’s best strategy.

What about Nippy? One of the idiosyncrasies of the NHS Pension is that there’s no ‘pot’ of money. The number you calculate is the annual pension you’d receive in retirement e.g. £60,000/yr. Fortunately there’s a way of calculating the capital value of your NHS Pension i.e. the equivalent ‘pot’ size. After doing so, Nippy’s NHS Pension has a capital value of £3m.

Value of pension income during retirement

You might argue that the size of the stash is irrelevant, it’s what you get from it that counts. How many years could each of the three draw an income equivalent to their basic, final salary?

Well for Nippy, they receive a pension income that’s greater than their basic final salary, each and every year from retirement until death. I think this is an under-appreciated point.

It’s grimmer reading for the other two, who may only be able to draw such an income for less than fifteen years. Even accounting for the fact that Nippy & Sippy will be paying income tax on their pension, whereas Zippy won’t, the non-NHS Pension strategies are exposed to some serious longevity risk.

Ah, you say, but Zippy is keeping their money invested instead of converting it to a big pile of cash they draw income from or an annuity. This naturally carries with it a degree of risk, leaving Zippy at the mercy of a deep, long market downturn (sequence of returns risk). If, however, their investment grows steadily, this would extend their ability to draw such a benefit to about twenty years.

Inflation

My calculations use a consistent 2% inflation rate. Of course inflation is not static for forty years at a time. In the last forty years (1981-2021), UK inflation has ranged from 0.4% to 12%. If inflation balloons, then it absolutely destroys the non-NHS Pension strategies – their value is eroded by lower real returns. Indeed, if inflation was, say, 4%, then you’d need a nominal return on equities of over 13% to match the NHS Pension. By comparison, the NHS Pension continues to grow above inflation by 1.5% regardless.

If inflation stays low, then it hampers the NHS Pension strategy. If it were 0.5% for the duration of the model, then the SIPP strategy ‘only’ needs a nominal annual return of 6.5% to overtake the NHS Pension’s capital value. It’s a similar story with inflation at 1% (7.9% nominal returns) or 1.5% (8.8% nominal returns). That still doesn’t eradicate longevity risk, because the NHS Pension will pay its benefits indefinitely until you die, whereas the SIPP won’t necessarily.

Bullish

You may feel that a 7% nominal return on equities is conservative. For the other strategies to match the NHS Pension in terms of capital value, you’d have to achieve 9.7% nominal returns for the duration of the accrual period. The S&P500 index has indeed achieved on average that amount over its ~100yr lifetime. Yet its worst twenty year period delivered ‘only’ 6.4%; what if you experienced one or more of these long periods with lower returns?

It’s also easy to retrospectively pick the best performing index from history and use that as a model. The future is much more opaque. How many SIPP investors would stick all their pension savings in one, foreign, stock market index fund and leave it untouched for 30-40yrs? Chances are you’d tinker, chances are you’d diversify your portfolio into fixed income as you near retirement, chances are you’re unlikely to pick the winner of tomorrow, today.

Bearish

You could conversely argue that a 7% nominal return is outlandish. Long-term data on the returns from equities vs. fixed income has the former outperforming the latter by approximately 4%. Using that 4% nominal return naturally exacerbates the difference between the NHS Pension and the alternatives.

Comparisons to alternative pension options also often neglect the fact that these vehicles come with fees of their own. Appreciably the total cost of a well-priced SIPP (platform fee + ongoing charge) is likely to be <1%, but that’s another <1% you’ll be having to earn in interest to break even.

More risk

In addition to longevity and sequence of returns risks there’s a diversification risk with the SIPP and ISA strategies. If both your pension and other investments are in equities, then all of them will lose value if there’s a large and/or prolonged market downturn. The NHS Pension doesn’t suffer this risk; it will revalue by treasury orders + 1.5% whether the market is up, down or sideways.

Uncontrollable

You might want to opt out of the NHS Pension because you want to exert more control.

The NHS Pension is, largely, outside of your control. There’s no option as to where your money goes. You simply pay your membership fee and then assume the gears of the great bureaucratic engine are turning. This may be unattractive for those who want to rule over their retirement finances with an iron fist.

There are ways of gaining some control within the NHS Pension (e.g. MPAVC’s), but overall these pale in comparison to that of, say, a SIPP.

I like to be in control as much as the next financier (and have the spreadsheets to prove it). Sometimes simplicity and automaticity can be beneficial, however. The inability to tweak and tinker is probably under-appreciated when it comes to investing. There’s that apocryphal story about the best investments belonging to those who either forgot about them or are dead…

If it weren’t for those meddling politicians

You might want to opt out of the NHS Pension because you feel it will be decimated by future legislative changes.

In my opinion there’s ample historical evidence to justify such a presumption. The nature of any interference is less predictable, though you could bet good money that it won’t make the scheme more generous.

You can eliminate this risk by opting out of the NHS Pension full stop. Naturally the downside is that you’ll miss out on the benefits, especially so if drastic detractions fail to materialise. Furthermore, you merely transfer 100% of the risk to whichever other pension roadmap you follow. What if legislative changes are punitive for SIPPs or ISAs just as much? No point moving all your eggs to another basket if it’s going to be dropped too.

My personal feeling is that it’s wiser to diversify pension strategies, to spread (albeit not eliminate) such interference risk.

Leaving the NHS

You might want to opt out of the NHS Pension because you don’t plan on working in the NHS long-term, which may include leaving to work overseas.

Opting out could make matters simpler by avoiding your pensions being spread out across multiple caches and/or countries. Naturally it may be difficult to predict your future career path with any great certainty.

If you were to opt out but then find yourself staying in the NHS, you may have missed out on some of the early benefits described above.

If you were to leave the NHS having already opted in, and wanted to take your pension with you, what happens then?

NHS Pension transfers

It is possible to transfer any existing NHS Pension, both domestically and internationally. As a rule of thumb it’s much easier to transfer out if you’ve been a member of the NHS Pension scheme for less than two years.

With fewer than two years’ membership, you can:
• Transfer into other defined benefit (DB) or defined contribution (DC) pension schemes. [The NHS Pension is a type of DB scheme, a SIPP is a type of DC scheme].
• Ask for a refund of your contributions to date
• Ask for a break if you intend to return to the NHS Pension scheme later on and don’t want a refund.

It’s still not a simple matter of clicking a few buttons, however. If the transfer value of your pension is over £30,000, you must provide proof of having received independent financial advice before you can proceed. As a reference point, the transfer value of your F1 contributions alone is likely to be over £30,000 (according to different calculators).

With more than two years of membership, things are even more limited. You’re unable to transfer your NHS Pension to DC pensions, though you can transfer to other DB schemes. These restrictions may seem Orwellian, but they’re borne of the fact that DB schemes such as the NHS Pension are so good. The FCA, ever a cautious bunch, say that “in most cases you are likely to be worse off if you transfer out of a defined benefit scheme“.

These sentiments are echoed by the Pensions Regulator, who “believe it is likely to be in the best financial interests of the majority of members to remain in their DB scheme“. Both comment that the value of a transfer is likely to be less than the benefits you’d otherwise receive.

You can ask for a transfer value if you wanted to do the maths yourself. It’s free and you’re not obligated to proceed with a transfer if you do so.

International transfers

You’re also able to transfer your NHS Pension benefits to certain, HMRC-registered, overseas pension schemes. Some of the same caveats as domestic transfers apply, such as only being able to transfer into DB pension schemes if you have more than two years’ membership.

There are other niggles that could make an international transfer poor value, including:
• A possible 25% overseas transfer tax
• Being stung by the lifetime allowance [as your pension benefits are tested against it at the time of transfer]
• Higher tax rates in your destination country [depending on its tax relationship with the UK]

An alternative option may be to have your NHS Pension benefits paid into your overseas bank account in retirement, although this too incurs a fee.

Transfers, domestic or overseas, are irreversible, which makes them a bit of a nuclear option. Their convoluted and constrained nature could make opting out from the off seem a more attractive option if you foresee your long-term employment being outwith the NHS.

Caution is due, however. As inimitable personal finance guru Pete Matthew concludes: “one thing’s for sure, there is no more controversial, challenging and potentially life-changing financial decision than the choice to transfer out of a DB pension scheme.”

More tax is bad

You might opt out of the NHS Pension because you’re concerned you’ll incur tax penalties, for breaching the annual (AA) and/or lifetime (LTA) allowances.

According to the models I used for comparisons earlier, both the NHS Pension and SIPP strategies would breach the lifetime allowance. It’s difficult, however, to predict what the LTA will be in the future. It’s previously been as high as £1.8m, is frozen at its current £1.07m for the next five tax years and there have been rumours that it’ll be reduced even further. It’s impossible to estimate the value of the LTA at the time of your retirement, though obtaining independent financial advice closer to the time seems a sensible strategy.

The annual allowance, particularly its tapered form, led to many consultants being stung with huge tax bills over the past few years. It’s seen many of them reduce their NHS working hours or indeed leave the service altogether. The government made changes in 2020 to mitigate this effect, which now means the majority of doctors will be unaffected.

Trying to accrue less pension in order to avoid either of these limits is a classic case of letting the tax tail wag the investment dog, an unwise strategy in most cases.

Retiring early

You might opt out of the NHS Pension because you want access to your retirement funds early.

That could be because you plan on early retirement, or simply prefer the flexibility of not having money tied up until a certain age.

In its raw form, the benefits from the NHS Pension can only be taken at state pension age (SPA), which is likely to be 68yrs for most readers. Some believe, not unreasonably, that SPA may well be 70yrs or more in the future. This is more restrictive than other vehicles, where you can withdraw your money earlier e.g. SIPPs (55-57yrs), LISAs (60yrs) or S&S ISAs (anytime).

You can access your NHS Pension early, although it’ll come with its benefits trimmed accordingly. For example, a member who would’ve expected £50,000/yr upon retirement at 68yrs, would only receive £27,000/yr if they claimed benefits at 55yrs instead.

What happens to our three amigos from earlier if they pull the plug on work at 60yrs? Nippy suffers a 33% pension benefit haircut for retiring early. Yet the capital value of their pension still outstrips all the other strategies. Despite the reduction for Nippy, the others lose out from having less time for compound interest to work its effect. They’re still at the mercy of longevity, sequence of returns and diversification risks too.

The NHS Pension has an optional mechanism for limiting the reduction if you did want to retire early; the ‘Early Retirement Reduction Buy Out (ERRBO)’. This allows you to retire up to three years before SPA without incurring a reduction in your benefits, though you’ll have to pay more throughout your career to do so. Whether or not this is ‘worth it’ is both tricky to model and will be highly variable between individuals. Risks of doing so include more eggs in the NHS Pension basket and greater risk of breaching the allowances.

Vexing complexity

You might want to opt out of the NHS Pension because you think it too complicated.

Undoubtedly the NHS Pension is more complex than your average pension scheme, hence writing the NHS Pension Series in the first place. Its translucent nature can make building a mental framework for what’s going on seem near-impossible. Many would prefer the simpler idea of paying money into a pot, which grows, from which you then withdraw in retirement.

In the face of NHS pension perplexity, opting out is probably the path of least resistance. However, in my opinion, self-education and obtaining professional advice are more rational behaviours, especially when it comes to the money you’ll live off in retirement.

Opting out of the NHS Pension

The point of this exercise isn’t to exalt the NHS Pension and denigrate other retirement strategies, or vice versa. The NHS Pension isn’t perfect, nor without its idiosyncrasies, though it remains a powerful tool for building wealth for retirement.

It’s not for me to tell you that you should or shouldn’t use an NHS Pension. What’s important is that if you’re making a decision, one way or the other, you’ve availed yourself of all the relevant information.

Your choice should be intentional, not on a whim or hearsay. As such, I would implore anyone to seek independent financial advice before thinking about opting out of the NHS Pension.

TTFN,

Mr MedFI


Assumptions
You’ve already read through the existing NHS Pension series to build a basic understanding of how the NHS Pension functions
• Pensionable pay = basic pay as described in the latest NHS Pay Circular
• Start F1 at 24yrs old
• State pension age 68yrs old
• Enter training programme directly from FY2, train to ST8, then work as a consultant thereafter
• Work full time throughout
• Annual inflation consistently 2%
• Annual, nominal (before inflation) return on equities consistently 7%
• 25 years of retirement income (68 – 93yrs old) as is the standard for defined benefit pensions (the type that the NHS Pension is)
• For comparisons of strategies I use the same gross input, although money put into ISAs is subject to income tax whereas that put into pensions (NHS/SIPP) is not.

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