NHS pension dilemma: what’s the best way to boost my retirement income?

A reader asks:“I’ve worked in the NHS three days a week for four years and am 15 years from retirement. I’m thinking about making additional contributions to the NHS scheme (I can afford £300 a month), but before I do, I’d like to consider alternatives – maybe regular contributions into a personal pension. Is that a good idea? Which one would leave me financially better off in retirement? My partner has a good job and should have a reasonable pension at retirement.”

Craig Rickman, personal finance editor, responds: First, it’s great that you’re taking steps to shore up your long-term finances. Fifteen years is ample time to make a sizeable difference to your lifestyle in retirement.

A quick glance on the NHS Pension hub shows you have two options to ponder when beefing up your workplace retirement savings: you can either buy additional guaranteed income or build a pot of money. Alternatively, as you’ve noted, you could pay into a personal pension.

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Before you commit to anything, it’s important to find out what your current provision will provide in retirement and think about your individual retirement goals. That may steer you towards the most appropriate option.

I can only provide information here, not advice. Given the weight of the decision, it might be a good idea to sit down with a regulated financial planner. For the purposes of this I’ve assumed you’re a basic-rate (20%) taxpayer.

How does the NHS pension scheme work?

The NHS offers a type of defined-benefit (DB) pension. Workers secure an inflation-linked retirement income based on number of years’ service and career average salary. The NHS website provides detailed information about how the income is calculated.

DB schemes are often described as “gold-plated” due to the iron-clad guarantees provided. Importantly, the nature of these guarantees means the risks are borne by the pension scheme, and not savers. As such, weighing up how to maximise this should normally be your first port of call.

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Your current pension contributions are deducted from your gross pay using salary sacrifice; a popular tactic that allows you to save national insurance (NI) as well as income tax on what you pay into a pension, which for basic-rate taxpayers totals 28% (20% income tax, 8% NI).

Let’s examine the options, and calculate what it might provide:

1) Get some additional guaranteed income

So, one possibility for your £300 a month is to buy extra, guaranteed annual income. You can purchase any amount in multiples of £250 up to a maximum of £8,575 a year.

I’ve crunched some numbers and found that a contribution of £414 a month gross (£298 after tax and NI is deducted) could buy an additional £4,000 a year in retirement. The total you’ll pay over 15 years amounts to £74,592. The mechanics here are that your salary reduces by £4,972 a year (£414 x 12) and instead goes into your pension, which keeps that portion away from the taxman.

Importantly, this income is inflation-proofed so the £4,000 a year is shown in today’s money. The amount that you’ll receive in 15 years’ time will therefore be higher. And this income continues to rise in-line with the consumer prices index (CPI), the UK’s main measure of inflation, once you start to draw from it.

So, what happens to this pension when you die? That depends on whether you select the dependent’s pension option, which could be your spouse, partner, or dependant children. You can add this facility, but it isn’t free; your total monthly payment will increase to £445. In return, each £250 of additional pension increases the dependant’s pension by £93.75 a year

When you reach retirement, you can take a tax-free lump sum, but bear in mind this will reduce your level of guaranteed income. Any income from the scheme will be taxed at your marginal rate.

2) Additional voluntary contribution

An alternative is to make additional voluntary contributions (AVC) through the NHS scheme.

In contrast to buying additional pension income, this money is invested in a fund or funds of your choice. The size of your pot at retirement depends on the amount you pay in and how well your investments perform over the years – hence why it’s called a defined contribution (DC) scheme. The NHS has negotiated special terms for its staff, which typically means lower charges.

That said, if you reach retirement and decide you’d like to use this fund to secure a guaranteed income, you can. And you have two options: you can either use the lump sum to buy additional pension as above (which is useful to know), or shop around and purchase a lifetime annuity.

Alternatively, if you would prefer to draw income flexibly in later life, you can switch your pot to something like a self-invested personal pension (SIPP).

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Like buying extra years, the NHS AVC scheme is also arranged under salary sacrifice, which again means your contributions escape both income tax and NI.

So, what sort of pot might you accrue in 15 years’ time?

Assuming you pay £414 a month, increasing by 2% a year to account for inflation, and the money grows by 5% annually net of charges, you would have a pot of £125,256.68. Note, what this will buy in 15 years’ time will be less due to the impact of inflation.  

Under current rules, you can take 25% of your total fund tax free, up to a maximum of £268,275. But you don’t have to make any decision while you’re saving, and bear in mind the rules concerning tax-free cash could change in the future.

If anything happens to you, a loved one of your choice can inherit the value of the pot on your death. If this occurs before age 75 there should be no tax to pay, provided the lump sum is paid within two years of the scheme being notified about your death.

But the key thing here is that, unlike additional pension, there are no future income guarantees – a key consideration, especially if certainty and security are important to you.

3) Private savings

As outlined above, there are compelling reasons to keep your pension savings within the NHS scheme, but you don’t have to.

Instead, you can stick your surplus income into a private pension or consider other savings vehicles.

SIPPs are also DC schemes, so operate in pretty much the same way as the NHS AVC plan. But you must be aware that while personal SIPP contributions attract income tax relief, you can’t swerve NI. Therefore, the upfront tax advantages under either NHS option are greater.

SIPPs are great for those who have maxed-out their workplace benefits, are self-employed, or would like to merge several older pensions under one roof for easier management and potentially reduced fees.

A final option to consider is individual savings accounts (ISA). While you don’t get relief from income tax or NI on what you pay in, the money grows tax free, and any withdrawals escape tax. What’s more, you can access your investments whenever you like – you won’t be restricted to age 57.

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However, if boosting retirement income is your core aim, pensions should typically be considered first due to the more generous tax advantages.

That doesn’t mean you should give ISAs the elbow. They’re a savvy way to supplement your pension savings with something more accessible – especially if you’d like a pot to fund pre-retirement goals.

There’s no reason why you can’t have both a pension and an ISA. This can bring some much-treasured harmony and flexibility to your investment portfolio.

So, which one would leave you better off?

Unless investment returns soar over the next decade and a half, buying additional, guaranteed pension is likely to be more lucrative. It also provides the closest thing to a like-for-like replacement to your salary, if that’s your objective.

However, if your current NHS provision will already provide sufficient guaranteed income in retirement, you might prefer to have greater freedom and improved death benefits with any additional savings.

The decision essentially comes down to risk. Do you want the certainty of knowing what income your monthly contributions will secure in retirement? Or are you happy to invest this money yourself, accept the unpredictability of investment markets, but with extra flexibility?

As with any aspect of financial planning, what’s right for you depends on your personal circumstances and retirement goals.