140- How The Annual Allowance Works In Defined Benefit Pension Schemes

Benjamin explains the key differences between defined contribution and defined benefit pension schemes and how they use up the annual allowance. 

By the end of this episode, you'll understand the intricacies of each scheme and be able to estimate how much of your annual allowance you are using and help to avoid nasty tax charges that many people are sleepwalking into. 

Knowledge is power, money nerds. This stuff is a tad complex, but once you've mastered it, it really is nailed down. 

Join Benjamin Mitchell (themoneyscot), serial hater of financial jargon, as he helps make your finances clearer and ensures you never make another financial mistake.

Getting on top of your personal finances doesn't need to be complicated or scary. Arm yourself with the only knowledge you need to transform yourself from money novice to money nerd! 

Take my 5 minute retirement assessment (can you already afford to retire?) 🚀


Disclaimer - please note that nothing in this podcast can be relied upon as financial advice and the content is provided purely for information and guidance purposes. Please seek independent, regulated financial advice relevant to your situation.

Transcript

SPEAKER_00 0:12

Good morning, good afternoon, good evening, money nerds, and welcome to episode 140 of Heads Up on Money. In this week, we're talking about the intricacies of how the annual allowance works when it comes to your pensions and how this differs depending upon whether your pension is a defined contribution pension or a defined benefit pension. Wow, that sounds riveting, doesn't it? Have I got your attention? Are you going to stick with me in this one? I really encourage you to do so because it's really important because this understanding of how the annual allowance works is really important to understand. Can you be paying more into pensions? Can you be using up more of your annual allowance? Or conversely, are you busting your annual allowance? Are you paying more into pensions than you are entitled to do so? Are you receiving more tax relief than you should? In which case you could face annual allowance tax charges, and that's a nasty, costly headache that you do not want to deal with. So, as dull, as hellishly boring as this episode sounds, do stick with me because it is nonetheless very important. So, anyway, let's get into this. It's the first episode of the 2026-27 tax year. It's an interesting one because normally understanding of this kind of stuff comes at the end of the tax year. Because clients quite often, certainly in my dealings with my clients, is towards you know February, March time, we will try and ascertain how much have you paid into pensions in the tax year, how much headroom do you have remaining within your annual allowance to pay into a pension? And key to that is working out uh effectively how much of your annual allowance have you used to your defined contribution pensions and your defined benefit pensions if you have one. So not everybody will have a defined benefit pension or final salary pension as they were previously known. Sometimes they've kind of reshaped now to be slightly more affordable for employers in the form of career average pensions, but the premise is the same, it's a defined benefit, you get a guaranteed income from a set retirement date for the rest of your days, whereas a defined contribution pension is very much just like an ISA in that you build up a pot of money, and there are certain tax rules accompanying that pot of money, that personal pension, that you have to abide by and plan around where possible, but the onus is very much on you to manage that money in a good way, or obviously if you have a financial planner or financial advisor doing this for you, but the onus is very much on you or your professional to grow that money and make it last for your lifetime. That's a defined contribution pension. And to understand how much you've paid into each of those flavours of pension is simple in the case of a defined contribution pension, but quite complex in the case of a defined benefit pension contribution. And it can be difficult to do end of tax year planning because it's a case of the chicken and the egg. You don't know how much of your defined benefit annual allowance you've used up until the tax year has elapsed, and often employers will give you your annual benefit statement, as they're often called, after the fact, after the end of the tax year. So it's really hard to actually do the planning. Now you can use unused annual allowance from the preceding three tax years to make additional contributions, but nonetheless, it is a challenge to get your head around this. So often you have to do best estimate calculations where possible. So I'm gonna give a bit of an overview on how the two ways in which your annual allowance is used up under a defined contribution and a defined benefit pension takes shape. And I'm gonna give a little bit of an overview, again, high level on exactly what the annual allowance is. So let's get into this one because I'm conscious it could be a bit more technical, it could be a bit lengthier than I'd like, and you would probably like, let's be honest. But let's get into it, and I'm convinced you're gonna get a bit of value nonetheless from this one. But just before I do, if you do enjoy heads up on money, I say it every week and you're probably sick of me saying it, but please do like, please do subscribe, and please leave me a comment if you're listening on Apple Podcasts because it helps keep the podcast high up the podcast money management charts. From me to you, thank you so so much. So, by way of a brief recap, what exactly am I talking about here? What does annual allowance even mean? Well, by summary, paying into a pension is is beautiful. It's great because you get free tax relief, free money from the government when you pay in. When you pay in, so too does the government. The idea being that they're not just being generous for the sake of it, but they're hoping that you will take ownership of your retirement and you'll be less dependent on the state when you do come to retirement. So they incentivize you to pay into a pension. Now, you can't have all your cake and eat it all in one go because there are certain thresholds and ceilings that cap how much you can pay into a pension in any one tax year. And the annual allowance as it stands at the moment is £60,000. It's changed over the years, it's been higher than that, it's been lower than that. If you're using carry forward from previous tax years, you do need to understand what the prevailing annual allowance was in each of those tax years that you carry forward from. But the simple, simple, simple way to think about this nowadays is 60 grand a year is what you can pay into a pension in any one tax year. Now that is only if you have relevant pensionable earnings of 60,000 pounds, if you earn 60,000 pounds. If you earn less than that, then your annual allowance will be capped at whatever your your earnings are. In previous episodes of the podcast, I've talked about, you know, two episodes ago we talked about planning for leading up to age 75, and if you've retired, you may no longer have relevant pensionable earnings, but you can still pay in a little bit towards a pension in any one tax year. In those cases, your annual allowance is shrunk right down to effectively £3,600 gross because that's for some reason an arbitrary amount that the government has said you can pay in if you are in those circumstances. But if an individual say has a gross salary of £32,750, then that is what their annual allowance will be. So your annual allowance will effectively be somewhere between £0 and £60,000, and if you earn above £60,000, let's say you've got a salary of £72,500, your annual allowance will be £60,000. £60,000 is the most it can be. Now there are caveats to this that I'm not going to get into. Your annual allowance can be tapered, so it can be reduced if you earn significant income. Again, not a matter for this podcast, but you have your annual allowance to contend with, you need to understand first of all how much is your annual allowance, and that will be determined upon your income level and how much it's tapered or not tapered. Then when you have your annual allowance and you say, like, okay, I've got let's let's let's use an example of an individual they're earning £76,000, their annual allowance will be £60,000. Okay. Now they need to understand that they've paid into perhaps pensions over the course of the tax year such that their annual allowance has been used up slightly. They've used up some of their £60,000 allowance. And they want to understand how much can we pay into a pension now to make sure we do not bust that annual allowance. Now, again, trying to keep us simple, folks, but you need to be aware of the premise of carry forward, which basically means if you've got unused allowance from any of the preceding three tax years, they can be carried forward to the current tax year to allow you to make a larger pension contribution in the current tax year. However, you just need to be aware that again will be capped at the level of your earnings. So technically speaking, this individual they could make you know a contribution up to their earnings, even though that's above £60,000 if they have unused annual allowance from the preceding three tax years. Whew, complex. But let's keep it simple. Let's assume they've got no carry forward, and in the current tax year they've got their £60,000 annual allowance. They have a defined contribution workplace pension and they have a defined benefit pension from when they perhaps had a, you know, they may have a an NHS benefits pension, they may have a private sector final salary pension that they're also paying into. And the simple way to think about this is that your defined contribution pension is dead simple. In terms of your annual allowance and how much of your annual allowance you have used up, it's simply how much money has gone into that workplace pension or personal pension. So if you pay in, let's say, a grand a month and that gets grossed up with tax relief to £1,250, say, then simply over the course of the year you will have paid in £12 times £1,250 over the course of that tax year. So in summary, this hypothetical individual will have used up £15,000 of their annual allowance. Really nice and simple, gives you much more control towards end-of-year tax planning, because you can accurately forecast how much you will have paid into your pension in that tax year. Where it gets more complex is with defined benefit pensions, because it's not a simple case of working out how much have you and your employer paid into that pension in that tax year. It is slightly more nuanced in that for divine benefit schemes, you don't really have a pot of money that grows. Instead, you're just promised an income from a public body, NHS pensions, for example, or perhaps a private divine benefit pension. And what you need to understand here is not necessarily what's been paid into the pension, but it's something called your pension input amount. I'll repeat that, it's called your pension input amount. And the pension input amount effectively is in very simple terms is working out how much is your promised future income worth at the start of the tax year, and how much has it grown by the end of the tax year? So effectively, if if at the end of the let's say at the end of the 25-26 tax year that's just passed, your pension was worth £22,000 a year, and at the start of the tax year, going back 12 months from there, it was worth £20,000, then the increase was £2,000, and there's a weird formula that HMRC use to understand this, but basically they multiply it by £16, which in this case would mean your annual allowance that's been used up is £32,000. So this individual, for example, would have used up £32,000 of their annual allowance to their defined benefit scheme and £15,000 of their annual allowance to their defined contribution scheme. Now where it's complex with defined benefit schemes, as I alluded to, was the fact you do not get these annual statements until after the fact, until after the tax year has passed, which makes it harder to do your planning. But you can do some calculations to try and estimate how much of your annual allowance you are using to your defined benefit pension. But again, it is not simply a case of understanding how much have you paid in, how much have your employer paid in, and that is what you've used of your annual allowance to your defined benefit scheme. That is the case for defined contribution, but it's much more subtle, much more complicated for defined benefit schemes. So if we were to summarize defined contribution, it would be simply we're measuring what are the contributions that's been paid in. It's highly predictable because you've got control over that, or if your employer's paying in, it's likely it's going to be a pattern that the employer is paying in, you've got much more control, even if it's salary sacrifice and you're not paying in technically yourself, but your employer is making pension contributions for you. It's highly measurable, highly specific, and highly uh highly known, so you can control how much of your annual allowance you've used and how much you may have remaining. I know some people, for instance, that maybe are having annual allowance issues and they they actually say to their employer, Would you would you mind not paying into my pension so as to not trigger an annual allowance charge and instead give me the income that you would have paid into my pension as a salary? Again, working that out is much easier in the case of defined contribution pensions. But with a defined benefit scheme, we're not measuring what's gone in, we're measuring how much it has grown, how much of the benefit's grown between the start and the end of the tax year. And where this causes lots of issues is this can vary significantly year to year. And often the things that can make a material impact to it and can end up with you busting the annual allowance is things that may not be within your control. So with defined contribution schemes, you've got ownership and control over how much you're paying in, and resultantly how much of your annual allowance you're using, but a defined benefit scheme, you do not have control because remember, the the formula for working out how much of your annual allowance you have used is measured by the growth in the benefits. And without going into the details too much and going into the formula behind this, is if you have a large spike in salary throughout the year, for instance, if you have received a significant promotion at work, then the the spike in the annual allowance can be immeasurably large. It can use up a high amount of your annual allowance, which can resultantly mean you've got no annual allowance remaining, and you having paid into a workplace pension or a personal pension, you may have busted your annual allowance. It can also vary depending upon what the inflation measures are that go into the calculations between the income, the incoming amount and the outgoing amount. And this has all kind of been brought into the news and the mainstream media with senior NHS consultants because they may be breaching the annual allowance without even realizing it. And because of unfair ways in which the NHS pension is is counted against the annual allowance, even small incremental jumps in salary can resultantly push you over the annual allowance. And again, I could get into the weeds of the subtleties of the NHS pension specifically, but that's for another date, that's for another episode of the podcast. The key takeaways here to understand, folks, is that when you pay into defined benefit pension, you've got less ownership and control over how much of your annual allowance you're using up. And typically you you you ramp through your annual allowance much faster and much quicker than you do with a defined contribution pension. And of course, it's not all bad because a defined benefit pension is incredibly valuable, it's incredibly a precious element of your financial plan in retirement because it's like the state pension, you get a guaranteed income for as long as you live. Often there's valuable death benefits to survivors or young children. They're great pensions to have, they're like gold dust nowadays in the private sector. But the caveat is they use your annual allowance faster by virtue of the way in which the calculation is administered, and this in some cases can cause tax charges. So knowledge is power, folks. You should hopefully now have got the basics from me in this episode to understand how your divine benefit contribution would work. And again, it can be difficult to understand how much of your annual allowance you have used into your divine benefit pension in any one tax year because you do not get the actual statement showing that until after the tax year. But you can work backwards to try and understand how much of your divine benefit pension you're going to use in any one tax year by trying to apply a guesstimate as to what you think your salary might be in terms of the end of the year, how much do you think your salary will have increased to? And you may also need something called your accrual rate. Again, your pension scheme should provide information of this, but your accrual rate is effectively saying you know how much of that salary is being banked every year. So for instance, let's say if you had a £60,000 salary and the accrual rate is £1 over 60, then that means £160 of your salary every year is banked. So in this case, £160 of £60, because I've kept the sums very simple for my little brain, is £1,000. So determining the accrual rate will have a key impact upon how much of your annual allowance you're using up. So effectively, you you just want to understand what your pension recrual was for the year, calculate how much your pension has increased over the course of that year, and that will give you your pension input amount if you multiply it by 16, as I talked about. Now, this is very rough, very high-level indications. Again, you may need to understand more about how CPI works in your scheme, the input CPI, the output CPI, all of that kind of good stuff. There has been some changes to the NHS pension over the last few years, whereby massive changes in CPI from one year to the next don't count aggressively against massive changes in your pension input amount. Again, getting into the weeds a little bit too much here, but you just need to know that you can provide some kind of estimation yourself on this. You can work out roughly how much of your defined benefit allowance you've used up in the current tax year. Again, it may differ depending upon when you actually get your benefit statement, which typically for public sector schemes is around about September, October time. They often have a legal responsibility to get it to you by then. But the matter of fact is that that will have been several months from the end of the tax year. So you've potentially already busted your annual allowance. So you want to provide as much certainty and calculation around this as possible. And in the event that you have busted your annual allowance, do remember that you may have unused allowance from preceding years that can be carried forward, which may help to alleviate or completely reduce the tax charges. So there we go. Have I still got you money nerds or have I lost you completely? I know it's a bit of a technical one, but if we were to just focus on the headline takeaways from today, is if you're an individual who have both defined contribution and defined benefit pensions and you are still accruing benefits within them, you are still using up your annual allowance within them, then the minutiae of how they both work will determine how much of your annual allowance is used up. It's very easy with defined contribution schemes because it's simply what you pay in and you have control over how much you are currently paying in and how much you plan to pay in before the end of the tax year. But when it comes to defined benefit pensions, it's not how much goes in, it's how much the benefits grow over the course of the tax year. Getting an accurate estimation of that within the tax year is nigh on impossible, but you can provide a rough calculation, which you can then verify with the data when it comes available to you. And understanding that both of these allowances contribute towards your headline annual allowance, which for most people will be £60,000. If you earn less than that, it'll be less than £60,000. If you earn more than that, it'll still be £60,000. Subject to some of the more flavorful caveats around tapering of annual allowance, or if you trigger the money purchase annual allowance. Again, I've got previous episodes of the podcast on this if you do want a deeper dive on some of these topics. But the headlines here are if you are working out your annual allowance and you have both flavors of pension, they are set up in different ways and use up the annual allowance in different ways. So having this knowledge will hopefully give you a bit of confidence to understand exactly how much of your annual allowance you're using, how you're using it, and hopefully it will avoid you encountering any nasty financial mistakes and annual allowance tax charges and keep you on the right side of HMRC. Okay, thank you as always for listening. Let's try and wrap this up in under 20. Have a great weekend, folks. I appreciate your time and your attention here. It's boring stuff, I realise that, but nailing down this stuff really does lead to financial wisdom, empowerment, and means you can focus on enjoying life knowing that all your money stuff is taken care of and you're not going to have any nasty shocks down the road. Okay, I'll wrap it up. Thanks as always for joining me. I'll catch you next Friday. Enjoy the rest of your week in the meantime, and I'll see you soon. Bye.