Increasing employer pension contributions at no additional cost to the business sounds too good to be true. But that is the position that many employers will find themselves in after introducing a salary sacrifice pension arrangement and deciding to invest the national insurance (NI) savings made in the company pension. Some, like business software company Coda, also find that their staff, encouraged by the NI and tax savings that can be made, decide to invest more money in their pension.
Dave Belmont, Coda’s group company secretary, says: “I am delighted as it has worked in everyone’s favour. More than 50% of staff are [now] paying more than the minimum contribution.”
If properly executed, pension salary sacrifice schemes can benefit all parties, with both employers and staff making significant NI savings. The government is apparently prepared to accept this loss in revenue as it fits with its policy on encouraging people to save more for retirement.
According to Employee Benefits/Aegon Trustee Solutions Pension Research 2006, 30% of employers now operate a salary sacrifice pension arrangement.
A relaxation of contribution limits following pensions tax simplification changes in April 2006 is credited by consultants for an increase in the popularity of such schemes.
Paul Farrell, head of flexible benefits at Aon Consulting, says salary sacrifice has become an established method of arranging contributions.
“Back in about 1998, a few clever organisations recognised the opportunities and promoted [salary sacrifice pension arrangements] quite strongly. At the time, the big employee benefits consultancies looked down their noses at this as almost scurrilous. Now they’ve realised it makes absolute sense.”
The benefits can be significant, with employees saving 11% NI on pension contributions made in relation to earnings between £5,045 and £33,504. Where earnings are above this range NI savings drop to 1%.
In addition, the organisation benefits from a 12.8% exemption on employer NI on pension contributions. With a large scheme the savings can run to hundreds of thousands of pounds.
HM Revenue & Customs (HMRC) says that the concept is an employment law issue and will only approve schemes retrospectively to ensure employers are paying the correct NI. This presents a potential headache for employers should they fail to make the grade, but consultants say very few schemes fall at this hurdle.
Damian Morrish, principal of the employee benefits division at Punter Southall Financial Management, says: “Obviously those of us that consult around this area have got it to such a fine art that HM Revenue & Customs is pretty unlikely to [disallow a scheme].”
Axing of schemes
But despite HMRC’s implicit acceptance of the practice, employers need only look back to the April 2006 Budget and the home computing initiative to see how quickly HM Treasury can axe tax advantageous schemes.
Before setting up a pension salary sacrifice scheme, interested employers must first decide if the concept will suit the organisation and its employees.
Julie Vile, a flexible benefits consultant at Watson Wyatt, says a feasibility study will identify where it is unlikely to work well.
One such case is where an organisation employs large numbers of people on the minimum wage, because the arrangement would effectively take these employees’ earnings below the threshold. Low-income earners may also find their entitlement to state benefits and tax credits adversely affected and are therefore usually financially better off opting out.
So, the decision whether or not to implement a scheme may not be clear cut for many organisations. If there is a range of pay scales in place the simplest course of action would be to offer salary sacrifice to those staff who would not be negatively affected.
Firms with high staff turnover levels may also find that salary sacrifice imposes a heavy administrative burden. Employers can decide whether eligible staff should be auto-enrolled or offered the opportunity to participate in a salary sacrifice arrangement.
Another issue which needs to be considered is entitlement to the state second pension. For low-to-medium income earners in a contracted-in scheme, state second pension benefits can be adversely affected by salary sacrifice because the lower salary means employees will accrue a smaller amount.
This issue does not generally arise for those in a contracted-out scheme as they are not entitled to a state second pension, unless they are among the low paid when they would typically be excluded from salary sacrifice.
Fraser Smart, a principal and senior consulting actuary at Buck Consultants, argues that consultants work to ensure that employees who opt for salary sacrifice are no worse off.
Salary sacrifice can also have a widespread effect on death-in-service benefits where pension scheme rules allow for a refund of employee contributions paid upon their death. Because the employer pays the money on the employee’s behalf, there are technically no employee contributions in a salary sacrifice scheme, and therefore no potential refund. Smart says employers can instead commit to pay members an equivalent sum should they die in service.
Employers should also pay reference to members’ pre-sacrificed salary when calculating benefits such as overtime rates and bonuses to ensure they are based on the original amount.
In addition, employment contracts should be altered to show sacrificed salary in order to satisfy the tax inspectors.
Once these issues are resolved, the success of the scheme will depend on a high level of take up to drive NI savings and cover the extra administration costs.
For this reason, Smart believes schemes are best suited to employers with more than 500 staff. He says a take-up rate in excess of 70% is necessary to make salary sacrifice worthwhile.
Neil Higginson, managing director of the provider Premier Employer Solutions, recommends that employers plan for a minimum of four weeks to communicate scheme changes effectively. “If you don’t communicate it right, and the fact it could have an effect on state benefits, you may well find yourself in big trouble, ” he says.
Employees should be given sufficient time to think about increasing contributions to take advantage of tax and NI savings that can be made. “[Some] people are sacrificing another 20% of their income,” explains Morrish.
Employers must also decide how they are going to use their savings from salary sacrifice. With many defined benefit schemes facing large deficits, NI savings can be used to help shore up the pension fund. Often employers also choose to use the savings they make to fund a flexible benefits or voluntary benefits scheme.
According to the Employee Benefits/AegonTrustee Solutions Pensions Research 2006, 38% of employers used the savings to make additional pension contributions, while 18% ploughed the money into other areas of the business. A further 16% used savings to fund a flexible benefits scheme, while 10% said the organisation pockets the cash.
Morrish points out that employers can opt for a mixed approach: “An organisation we dealt with recently said the employees will get 80% of the savings for the first two years and the [other] 20% will pay for the project costs. Thereafter they get 100% of the savings invested in the pension scheme.”
Farrell says employers should warn staff that any sharing arrangement for NI savings is not guaranteed. “The critical thing is that if the employer is sharing [NI savings] in any way, to make it clear that if those goalposts are ever moved, then that extra remuneration may disappear.”
Case study: Coda
Coda, the business software company, replaced its three trustee-based pension schemes with a salary sacrifice group personal pension plan in April 2006 ahead of the company’ s demerger with its SciSys division in September. Dave Belmont, group company secretary, said salary sacrifice allowed the company to increase the contributions it made to employees at no extra cost.
CodaSciSys previously contributed 6.75% of salary conditional on an employee contribution of 3.25%. Following the demerger, the minimum contribution for employees stayed the same, but the amount from the company rose to 7%. Should employees opt to invest 5% the company pays 7.25%, rising to 8.5% in return for a 15% employee contribution. The impact of the changes were demonstrated to staff prior to the scheme’s launch via a communication campaign undertaken by consultants Premier Employer Solutions.
As a result there was a 97% take-up rate with just 12 employees opting not to take part in salary sacrifice. Belmont says that 50% of employees have also chosen to increase contributions.
Issues for employers
Salary sacrifice pension contribution vehicles work best in medium- and large-sized organisations where members earn well in excess of the minimum wage.
Enrolment of members
Employers must decide whether to invite members to voluntarily take part in the scheme or to auto-enrol them. The latter option is popular as the take-up rate must be high to make salary sacrifice worthwhile.
Salary sacrifice will demand an increased amount of administration and may involve changes to payroll and pension systems.
Employers may consider introducing new levels of both employer and employee contributions when salary sacrifice is implemented.
Distribution of savings
Employers have used NI savings in a variety of ways, including funding voluntary and flexible benefits schemes, or to shore up a pension fund.