Salary sacrifice provides an ideal opportunity for staff to boost pensions payments and employers to make savings
When it comes to pension costs, one of the most difficult issues organisations face is assessing what the level of take-up will be and what budget to allocate to a scheme.
There are several scenarios where the objective will be to keep uptake low, for instance if a company is backed by venture capitalists, or an organisation has to meet Tupe rules - the Transfer of Undertakings (Protection of Employment) Regulations - where the employer will often put in the minimum provision possible to meet legal requirements.
Conversely, where an employer is switching from a defined benefit to a defined contribution scheme, the organisation may want to make a big effort to encourage maximum engagement to try to soften the blow to the workforce.
While running a pension scheme can obviously attract significant costs, one way to reduce these is to offer employees the chance to make their pension contributions through salary sacrifice. This allows the employer to make national insurance contribution savings of 12.8% on the part of the employee's gross salary being sacrificed. The employee, meanwhile, sees a reduction in their salary on which tax and national insurance contributions are usually payable. These savings vary depending on whether they are a loweror upper-rate tax payer.
The easiest way to work out what savings could be achieved is to do a few sums. If, for example, a basic-rate tax payer sacrifices £149.25 as a pension contribution, a quick calculation shows that this is equivalent to a £100 net pay reduction due to the £49.25 tax and national insurance contribution savings made (see box 1 below left).
The employer's 12.8% national insurance saving on the amount of £149.25 is £19.10. This will typically be used to either enhance the employee's pension or provide other benefits. If the employer adds its national insurance savings to the employee's pot, the total gross contribution could end up at £168.35 (£149.25 plus £19.10).
The potential savings for higher-rate tax payers on national insurance contributions are not so great because those earning more than £34,600 (in the 2007-08 tax year) are only eligible to a 1% saving on the amount sacrificed. This is because if they earn £50,000 and pay £5,000 a year in salary sacrifice contributions, this only takes their salary to £45,000 and the national insurance that they would have paid on the £5,000 would have been 1%, while salary below £34,600 attracts national insurance contributions of 11%. Higher-rate tax payers do, however, get higher tax savings on their contributions at 40%.
Andy Savage, senior consulting director at Jardine Lloyd Thompson, says: "Most employers will give a good proportion of their savings back because they've got used to paying it, but they may retain some for costs, for example legal costs, or to provide a benefit such as life assurance. Those that don't, may raise suspicions among the workforce, because these things are now better understood."
Salary sacrifice schemes are not appropriate for people whose salary would be reduced below the national minimum wage as a result of joining. There are also issues for those who take certain state benefits, such as statutory sick pay, maternity pay and the second state pension, as they are linked to the employee's total gross earnings and a reduction in their taxable salary may reduce their entitlements. Care is also needed where employees are in receipt of tax credits.
Case Study: Eli Lilly Drugs company†
Eli Lilly has operated a non-contributory final salary scheme since the 1970s, and introduced a salary-sacrifice flexible benefits package, Lillyflex, for its 2,200 staff in June 2004.
One of the benefits is a top-up pension, known as Special Employer Contributions (SpECs), which offers employees the opportunity to sacrifice up to 15% of their salary. The firm then effectively makes an additional voluntary contribution (AVC) on the employee's behalf by paying 5% of the national insurance savings it makes from the employee's contribution. The remaining NI savings are used to fund Lillyflex, as the scheme is structured to be cost neutral.
Before the introduction of Lillyflex, 800 of the then 2,600 staff were making traditional AVCs to top-up their pension. In contrast, more than 50% of the current 2,200 staff have paid into either SpECs or made AVCs, representing a substantial rise in overall saving. Julie Osman, director of pensions and benefits, says: "The percentage of staff saving for retirement has gone up 65%."
| WBasic rate tax payer |
Salary sacrifice£149.25
Employee NI saving at 11%-£16.42
Tax saving at 22%-£32.83
Net pay reduction£100.00