One relatively pain-free way for staff to increase their pension contributions is through salary sacrifice. Ian Bird details what this involves for employees and employers, and points out the downsides.
2012 will see a huge change in the pensions landscape. In an attempt to find a long-term answer to the UK’s pension crisis, the government is introducing Personal Accounts, a new national scheme.
Overall, the objective is to significantly increase the number of people saving in a pension plan for their retirement. The legislation will give UK employers three options for eligible employees: enrol everyone into a Personal Account; enrol everyone into the organisation’s existing pension plan (provided that it offers the equivalent financial benefits as a Personal Account); use a combination of the two depending on peoples’ needs and preferences.
As with any major change, organisations that start preparing well ahead of the event will face less upheaval. Early adoption will prevent them facing a sudden increase in expenses – both in terms of the contributions themselves as well as additional administration costs for running the scheme – in 2012. In addition, it should ensure they do not risk penalties for non-compliance.
One potential solution that can be introduced now is a salary sacrifice scheme. This is a contractual agreement between employer and employee, whereby the employee opts to reduce their take-home salary in exchange for a non-cash benefit provided by their employer. In the case of pensions, contributions into an employee’s fund are increased as a result of reducing their taxable earnings.
Salary sacrifice schemes can be used with group money purchase, personal pension or stakeholder plans. They offer a direct benefit to employees because their pensions are boosted at no additional expense to them. At the same time, they enable employers to provide an organisational pension programme without a large rise in outgoings.
Employees opting for a salary sacrifice scheme agree with their employer how much of their salary they will ‘forego’ in order that it can be paid as a pension contribution. There is then an additional benefit in the form of reduced national insurance (NI) obligations. Currently payable by the employer at a rate of 12.8% of an employee’s salary, no NI is required on pension payments. Therefore, the overall NI liability is reduced in line with the income decrease.
Employers are not legally obliged to pass this on to their staff. But the majority recognise that this is an easy method of supporting employees at no additional cost to anyone. Therefore, the amount saved through NI is usually transferred to the employee, either via a direct increase in the pension payment, or through funding additional employee benefits, such as childcare vouchers, gym memberships or healthcare schemes.
This may be particularly critical during the currently challenging economic environment. While organisations need to manage costs tightly, they must also recruit and retain high-calibre employees. The ‘NI bonus’ offered by a salary sacrifice scheme gives them additional means to do this.
And, there is no denying that pensions are a highly complex topic, currently hindered by the lack of financial literacy in the UK. I would argue though that both pension providers and employers have a responsibility to ensure this issue is tackled before 2012. Any pension scheme should be accompanied by an ‘education’ programme that will see employees advised on the process and implications in order for everyone to have the chance of a pension plan to match their individual needs.
Employees therefore need advice so that they understand both the pensions’ benefits that their employers are providing and as a way of helping them secure their financial futures. This requires organisations to put specific emphasis on the way they communicate the introduction of any pension arrangements – and this may be particularly critical for salary sacrifice schemes, so that the full benefits they offer are recognised.
However, it must also be remembered that salary sacrifice schemes are not a ‘one-size-fits-all’ fix for 2012. For example, they potentially take employees in lower-earning roles below the minimum wage. Not only is this illegal, but it has serious implications on staff morale.
Equally, people who are aiming to take out a mortgage must factor in that reducing their income, albeit to increase their pension payments, may have an impact on the amount of money they can borrow. Likewise, maternity pay, which is usually calculated as a percentage of earnings, can be affected by a salary sacrifice pension scheme.
But these are the exceptions. Administered clearly and communicated well, salary sacrifice remains a low-risk, cost-effective way for organisations to prepare themselves and their employees for the introduction of Personal Accounts in 2012.
Ian Bird, senior partner, Foster Denovo
Example of salary sacrifice in practice
Without salary sacrifice
- John Smith earns £30,000 a year before tax and pays £1,200 into his pension fund. He pays £4,705 in tax and £2,670 in NI contributions each year to give him a net disposable income of £21,425.
With salary sacrifice
- John Smith earns £30,000 a year and sacrifices £1,500 from his salary into his pension. He pays £4,405 in tax and £2,505 in NI contributions each year to give him a net disposable income of £21,590. His employer pays the 12.8% NI saving into his pension to give him an annual contribution, including tax relief of £1,692. By using salary sacrifice, John has increased his take home pay by £165 per year and increased his pension contributions by £192 year. There are other considerations to bear in mind when implementing salary sacrifice and it is important to take advice on this. Levels and bases of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor.
Source: Foster Denovo