Translating the New USS Pension Rules Into Plain English

8 Sep 2016 | Investment Strategies

Andy Haldane, the Chief Economist of the Bank of England, said that pensions are so complex that even someone “moderately financially literate” like he can’t understand them. This complexity certainly applies to pension tax rules when combined with changes to the Universities Superannuation Scheme (for employees of UK universities): despite being a finance professor, it’s taken me ages to understand the changes, but I think I’ve finally figured it out. I thought I would share it in simple language to help others also. CAVEAT: I’m not a financial advisor and what I write should not be construed as financial advice. You should speak to your university’s Pensions Manager or a financial advisor (Mercer helped at LBS); my goal is to give you an understanding of the basics which they can then bring to a conversation with your advisor. In addition, there will likely be future USS and tax changes; this document is only intended to be accurate for the time of writing.

(I apologise for a non-standard post which will only be of interest to USS members. The goal of my blog is to translate complex academic research into simple language for a non-finance audience. But, since the USS scheme is as complex as an academic paper, I thought it also needed to be translated.)

What Does The Scheme Involve?

  • From 1 Oct 2016 there will be two sections of USS
    • Retirement Income Builder, a Defined Benefit Scheme. This applies to contributions up to £55k of salary. Thus, if your salary is at least £55k, 1 year of service gives you £55,000/75 = £733/year (taxable) extra pension, plus a tax-free lump sum of 3 x £733 = £2,200.
      • Tax Now. This is capitalised at 19x for tax purposes. The promise of £733/year, every year from retirement until death, plus the lump-sum of £2,200, is said to be “worth” £733 x 19 = £13,933 today. This £13,933 is counted as “income” and potentially taxable.
      • Tax Later. Upon retirement, the above promise is said to be “worth” £733 x 23 = £16,859. (You increase the 19 to 23, since the £733/year starts immediately so it’s worth more). Your DB pension pot is thus £16,859. You can indeed take this as a tax-free lump sum of 3 x £733 plus a £733/year (taxable) pension. Or you can increase your tax-free lump sum up to 25% of your £16,859, and your annual pension is reduced accordingly (known as “commutation”).
    • Investment Builder, a Defined Contribution Scheme. This applies to contributions above £55k. If you earn above £55k and stay in the scheme fully, 20% of your income above £55k (12% contributed by your employer, and 8% by you) is invested in funds of your choice, out of USS’s offering.
      • Tax Now. If your income is £255k (I choose this to make round numbers, not because it’s realistic!), your contribution to this section is 20% x (£255k  – £55k) = £40,000. This is counted as income and potentially taxable.
      • Tax Later. The value of the DC pot upon retirement depends on fund performance. On retirement, you can take 25% of the fund value as tax-free cash. The remainder is used to purchase a pension annuity (i.e. converted into an annual income for the rest of your life), on which you pay income tax.
  • The tax-free pension Annual Allowance is £40,000, but if your “adjusted income” (income plus pension contributions by you and employer) exceeds £240,000, for every £2 increase in your adjusted income, your allowance falls by £1, down to a minimum of £4,000. Anyone earning over £312,000 will have the minimum allowance of £4,000.
    • If your total pension income (from both sections) exceeds your annual allowance, you pay tax on the difference at your highest marginal tax rate. In the above example, total pension income is £13,933 + £40,000 = £53,933, vs. an allowance of £10,000. The taxable income is £43,933. You pay tax at 45%, i.e. £19,770. (I assume 45% tax given the income of £255k, but you should use your own tax rate).
    • If it’s below, you can carry forward your unused allowance for up to three years
  • There is also a Lifetime Allowance of £1 million. If the total value of your pension pot (accumulated over your life) exceeds £1 million, then upon retirement you pay 25% on the excess, if you take the excess as a pension (on which you then pay income tax) or 55% if you take the excess as a lump sum. If you are a 40% taxpayer, the net effect of a 25% tax then 40% on the excess is the same as a one-off tax of 55% ((1-40%)*(1-25%) = (1-55%)) so tax is the same under both options. Your pension pot is the sum of
    • The value of your annual pension under the DB section multiplied by 20
    • Any tax-free cash you decide to take from the DB scheme
    • The value of your DC pot (including any tax-free cash)

What Are Your Options?

1. Stay in the Scheme Fully

The £255k/year earner counts his income as the full £255k for pension purposes. Then:

  • Benefits
    • Income upon retirement from the DB section rises by £733/year (or less if you take out tax-free cash)
    • 20% of (£255k – £55k) = £40,000 goes into the DC funds
  • Costs:
    • Pension contribution of 8% on the full £255k salary, which comes out of pre-tax income. This is your contribution to the DB and DC schemes. Employer pays 18% (only 12% goes into the DC pot because 6% is used to offset USS’s deficit)
    • Tax on the excess contribution above the Annual Allowance (£43,933) at your top marginal tax rate
    • Potentially more tax upon retirement, because your contributions enter into your total pension pot and may end up breaching the Lifetime Allowance by more

2. Enhanced Opt Out

Opt out of the scheme fully, i.e. don’t contribute to your pension. Since your employer no longer has to pay 18% employer’s contributions, it instead pays you a Salary Supplement as extra income, which is taxed. At LBS this is 13% of your salary (13% x £255k = £33,150 in our example), but check with your employer.

  • Benefits
    • An extra 13% of your salary, which is taxed
  • Costs:
    • You still have to pay 2.5% for life insurance and incapacity benefit. So, you save 5.5% compared to the 8% you’d have contributed by staying in the scheme

You still have your £10k Annual Allowance that you can use for a Self-Invested Pension Plan outside USS. Mercer advises that you should almost never choose the Enhanced Opt Out. This is because the DB scheme is attractively priced, so you should stay in the scheme at least up to the DB limit of £55k.

3. Voluntary Salary Cap

This is a hybrid. You cap your salary for pension purposes at a “Voluntary Salary Cap” level that you choose, which cannot be lower than the DB threshold of £55k. Up to the VSC, you pay 8% contributions and your employer pays 18% contributions. On the difference between the VSC and your salary, you pay 2.5% to maintain death in service and incapacity benefits on your full salary, and your employer pays you 13% (because it’s saving the 18% contributions)

Let’s assume a VSC of £155k. Then, pension contributions up to £55k go into the DB section; contributions on the remaining £100k go into the DC section.

  • Benefits
    • Income upon retirement from the DB section rises by £733/year (or less if you take out tax-free cash)
    • 20% x (£155k – £55k) = £20k goes into the DC funds
  • Costs:
    • 8% contribution up to the VSC of £155k
    • 2.5% for death in service and incapacity benefit on the (£255k – £155k) = £100k excess
    • Tax on the excess contribution
      • Pension income £13,933 in DB plus £20,000 (not £40,000 due to the VSC) = £33,933. Annual Allowance stays at £10,000 (it’s based on your actual salary, not VSC). You pay tax on the excess of £23,933.
      • Less Lifetime Allowance tax upon retirement than under (1) but more than under (2).

Under (1), and under (3) up to your VSC, you can increase your 8% contribution by 1%, which is matched by your employer. This counts towards your AA and goes into the DC funds. You should almost always do this, to benefit from the employer match.

What To Do

I reiterate that I am not a financial advisor and this should not be construed as financial advice. But, in my opinion, the decision can start from a simple calculation.

For most employees, you won’t hit the Annual Allowance or Lifetime Allowance, so you stay in the scheme fully. The decision is only complex for higher earners. You should almost never consider 2, since the DB scheme is so attractive. If you consider 3, you should almost always choose a VSC of £55k and no higher. (If it’s useful to cap, it will be useful to cap all the way). Thus, the choice is: do I stay in the scheme fully, or impose a VSC of £55k?

Stay in the scheme fully. For every £1 of your salary, 20% goes into the DC funds. You pay 45% tax on this right now. Upon retirement, you draw an income from your DC funds and have to pay 45% tax. However, you can take 25% out as tax-free cash, so you only suffer 45% tax on 75% of your pot. (This tax is paid later, but will be paid on a higher amount as your funds should grow, so “time value of money” considerations should roughly wash out). Thus, every £1 of salary gives you £1 x 20% x (1 – 45%) x (1 – 45% x 75%) = 7.29p.

VSC at £55k. You save 5.5% by making pension contributions of 2.5% rather than 8% on your income above £55k. This increases your taxable income as these contributions would have come out of pre-tax income. You receive a 13% salary supplement from your employer, which is taxed. The total net gain is 18.5%. Thus, every £1 of salary gives you £1 x 18.5% x (1 – 45%) = 10.18p.

Thus, it seems a no-brainer to engage in the VSC. Essentially, 20% of your salary taxed twice (once now, once at retirement) is worse than 18.5% of your salary taxed once (now). However, there are other considerations:

  • If your tax exceeds £2,000, you can pay it out of your pension pot (known as “Scheme Pays”) rather than actually having to pay the tax with cash. This is advantageous, because you save having to pay tax on your pension pot at retirement – so now the comparison is 20% taxed once (not twice) with 18.5% taxed once. (While the money in your pension pot has already been taxed upon contribution, if you paid the tax with cash it would be from post-tax cash, so this consideration evens out). However, you don’t want to pay this out of your DB benefits, since the DB section is attractively priced. Thus, stay in the scheme fully for a few years, in order to build up enough DC funds to be able to pay tax on the excess above both Annual Allowance and Lifetime Allowance
    • In the above example, even if you VSC at £55k, you still have to pay tax on the excess of £13,933 above your AA, so it’s good to have built up DC funds to pay this
  • Having the 18.5% as cash rather than 20% in a DC pot is attractive as you can do what you like with the money. Even if you choose to invest it, you have a wider range of choice than the USS funds. (Against that, the USS funds have no Annual Management Charge, except the emerging markets fund that charges 0.15%).
  • USS has a huge deficit, and so it may default on its DB promises. If USS goes into the Pension Protection Fund (effectively a default), the actual value of pensions will be significantly lower than the promised value.

Personally (this is not advice, this is only what I am choosing to do), I will stay in the scheme for many years. This is because, due to my age, I have several decades until retirement and will likely exceed the Lifetime Allowance, so I would like to build up DC funds to pay both Annual and Lifetime tax. Then, I will VSC at £55k (or whatever the DB threshold happens to be at the time), because 18.5% taxed once (and which I can use freely) is better than 20% taxed twice. Mercer had a proprietary model calculating what year I should initiate the VSC based on my age, income etc. Your advisor should have one too.

If anything in this is inaccurate, please post a comment below. I would like this to be as accurate as possible and value all input. Thanks to many folks who’ve already corrected errors and omissions in prior drafts.