'Smart pensions' or salary sacrifice
This is an increasingly popular device to
reduce the cost of pensions. Essentially, it involves employees'
salaries being reduced by the amount of their pension contributions
and those contributions instead being paid directly by the
employer.
With the cost of pensions rising this device
can make a small but very significant contribution to the
affordability of pensions.
The reason for doing it is that the lower
level of pay means National Insurance contributions are reduced
both for employers and employees. The total savings amounts to
about 20% of the value of the pension contribution which, if
nothing different was agreed, would be divided equally between the
employer and employee. This means employees take-home pay is
increased as compared to the pre-sacrifice situation.
When the concept first emerged it was thought
that it was tax loophole, which the Government would soon move to
close. But there is no sign of this happening. This angle ignores
the fact that there quite a few pension schemes that have always
been non-contributory for employees and that, insofar as salaries
may have been lower because of that, their members could be
regarded as already in the position which salary sacrifice takes
you to.
There are some particular pitfalls with
salary sacrifice which mean that it is not suitable for everyone
and, on a more general basis, safeguards need to be built-in if
members are not to be disadvantaged by their salary being
reduced.
Safeguards
Careful account needs to be taken of all
pay-related benefits to ensure they are not reduced by the salary
sacrifice. Items like overtime, shift etc may be calculated by
reference to the basic rate.
The best way of dealing with these is for it
to be established that they will continue to be calculated, both
immediately and in the future, by reference to what salary would
have been had the salary sacrifice not taken place.
In practice this is often done by using a
notional reference salary for calculating the benefits.
Where members are in defined benefit pension
schemes, where the amount of pension is defined by reference to
final salary, then a similar safeguard needs to be introduced.
Otherwise there could be a big impact both on the value of past and
future service pension entitlements.
What about state
benefits?
The major potential effect here is on members
entitlements to State Second Pension (S2P – the successor to
SERPS).
Basic State Pension would only be affected if
the salary reduction dropped a members earnings below the National
Insurance threshold (or LEL, which is currently £4264 p.a)
and so only need be a concern for low paid/part-time
employees.
The effect of salary sacrifice on S2P depends
on whether the employee is contracted-in (participating) to S2P or
whether they are contracted-out, with much the biggest impact where
people are contracted-in.
Defined contribution (money purchase)
pensions are very often contracted-in whilst defined benefit (final
salary) schemes are most often contracted-out. The numbers of
people who are contracted-in has been rising rapidly.
If you are contracted-in then for the
majority of employees S2P benefits are directly reduced by salary
sacrifice. The complexity of S2P means this is not a
straightforward picture but people whose gross earnings are in the
range of £12000-£32000 will lose out by amounts which increase the
older that they are. These losses could for some take away a
substantial part of the gains from salary sacrifice.
Where salary sacrifice in proposed in a
contract-in situation, employers should be asked to quantify and
advise members on the impact on S2P.
Where employees are contracted-out the losses
are much less and confined to the lower paid because to a large
extent their scheme benefits replace S2P. But lower earners do
still get a substantial top-up S2P payment which will be directly
reduced as their gross salary is reduced.
General considerations
Where any proposal is introduced it would
expected that it would be accompanied by clear information as to
who might stand to lose as well as who might stand to gain.
While the gain from NI savings may be similar
for employees and the employer employees may lose out significantly
from reduced S2P benefits. This could support suggestions that part
of the employers' savings might be channelled back in some sort of
benefit for employees.
Salary sacrifice may also be linked-up to a
'flex', or flexible remuneration, package whereby a range of
benefits may be accessed as an alternative to salary with similar
savings in National Insurance coming into the picture
(Amicus Pensions – June 2005)
