Salary Sacrifice

Salary Sacrifice can be a popular device to reduce the cost of pension contributions. The reduction is achieved by avoiding paying NI contributions on the part of pay that would be paid in employee pension contributions.

Essentially, it involves employees’ salaries being reduced by the amount of their pension contributions and those contributions instead being paid directly by the employer.

In 2011/2 employees pay NI at the rate of 12% (or 10.4% if they are contracted-out) of their gross pay between £7228 p.a. and £42,484 p.a., and 2% of their gross pay above that level.  This means that for most employees the saving they make is worth 12% (or 10.4%) of the value of their pension contribution and the benefit would appear in the form of higher take-home pay. For those on high pay the saving would be only 2% of the value of their contribution.  The employer also makes a saving generally worth 13.8% of the employees pension contribution, whatever the employees salary level (only 10.1 % on the part of salary less than £42,484 if the employee is contracted-out)

While salary sacrifice is generally advantageous safeguards need to be built into schemes to avoid obvious sources of disadvantage to wider pay and pension calculations. Also members’ gains may be compromised by lower state benefits

Careful account needs to be taken of all pay-related benefits to ensure they are not reduced by the salary sacrifice e.g.. 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.
Future pay rises should always be determined by reference to the pre-sacrifice salary level.

What about state benefits ?
The major potential effect here is on members entitlements to State Second Pension (S2P). The effect of salary sacrifice depends on whether the employee is contracted-in (participating) to S2P or whether they are contracted-out, with a bigger impact where people are contracted-in. 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 £14000-£40000 will lose out by amounts which increase the older that they are. These losses could for some take away a significant part of the gains from salary sacrifice.

Where salary sacrifice is proposed in a contracted-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 because to a large extent their scheme benefits replace S2P. But lower earners do still get a significant top-up S2P payment which will be directly reduced as their gross salary is reduced.  In most circumstances salary sacrifice will still deliver a substantial net benefit to members, but S2P losses mean that employees will gain a lot less than employers.

Employees on very low pay should be excluded from salary sacrifice for two reasons. Basic State Pension would be affected if the salary reduction dropped a members earnings below the N I threshold (or LEL, which is currently £5304 p.a. In a similar vein a salary sacrifice would not be allowed if it took members pay below the National Minimum Wage.

General considerations
Salary sacrifice needs to be properly communicated if it is to gain employee support.
It can be introduced either by members being invited to opt-in or by employees being included but advised of an option to opt-out. While the latter strategy may be pressed to overcome member inertia and suspicion it should not excuse the employer from properly communicating the scheme
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 should support suggestions that part of the employers’ savings should be channelled back in some sort of benefit for employees e.g. to offset a part of a contribution increase in a defined benefit scheme or to provide a supplement to the employer contribution in a defined contribution scheme