BeeHive > BeeLines > Salary Sacrifice
Salary Sacrifice
With all the focus from the Department for Work and Pensions (DWP) lately around soft compulsion (or automatic enrolment), see the recent BeeLine on that by clicking here if you like - Soft Compulsion, I thought it might be a good time to write about the issues surrounding salary sacrifice schemes and, particularly, this relatively new idea of automatic salary sacrifice. Automatic’s becoming a bit of a pension buzzword at the moment isn’t it? Anyway, I’ve been thinking about writing on this aspect of company pension provision ever since I said in one of my recent talks that some people have to realise that salary sacrifice could lead to them losing out on valuable statutory benefits. I know it’s obvious, but if you earn less and pay less in National Insurance, which is the whole point of salary sacrifice schemes really, then benefits that depend on your earnings levels and the amount of National Insurance Contributions you make will be affected. That’s not that hard to understand.
The thing is, though, as I was speaking at a conference for Independent Financial Advisers I should really have known better than to have made such a sweeping statement. It led to the obvious question being asked that went something along the lines of “Exactly what statutory benefits are you talking about then?” Now, that was a good question, particularly as I’d said that employers promoting salary sacrifice should really explain all this in detail to the employees involved so that they could make rational and sensible decisions. I had a go at giving an answer and said that things like statutory redundancy pay and entitlement to State Second Pension benefits could be hit, as well as things like the ability to raise a higher level of mortgage loan. But it wasn’t a convincing answer and I think most people realised I was skimming it.
When I got back to the pile of paper and books that fill my office I thought it would be a good idea sometime to read through my dusty volume of ‘Social Security and State Benefits’ with a view to writing a fairly comprehensive BeeLine on the subject. That’s what I’m doing now. This is it. As comprehensive as I can get it, anyway.
First, though, before I go through all the tedious detail, it might be a good idea to say just what salary sacrifice is all about, and explain a bit about how it works. If you already know this, of course, you can skip this next bit. I won’t mind.
Salary sacrifice is a term used to describe what is going on when an employee gives up the right to future remuneration in return for their employer paying the money into the employee’s pension pot instead. The big advantage of this is that both the employer and the employee will not have to pay National Insurance Contributions (NIC) on the earnings foregone and, in many cases employers are prepared (or can be encouraged) to divert their own NIC savings into extra pension contributions for the employee. I mean, it’s no skin off their noses is it?
So, for example, think of an employee who is earning £25,000 and decides to give up £1,000 of their salary. That, of course, would leave them with a salary of £24,000 instead of £25,000 and the agreement between the employer and the employee would be that the employer would pay the foregone £1,000 of salary into the employee’s money-purchase pension scheme instead. (By the way, this stuff can work with final-salary schemes too, but it’s not that straightforward so I’ll only be talking about money-purchase schemes here.)
Employees pay 11% in National Insurance Contributions on earnings above something called the Primary Threshold (which is £4,895 in the 2005/6 tax year) and employers are required to pay 12.8%, so the respective savings in National Insurance on the £1,000 of ‘sacrificed’ salary are £110 and £128 (this wouldn’t be the case, by the way, if the reduction in salary took someone below the Primary Threshold, obviously). From the employee’s point of view this means that the real cost of the £1,000 pension contribution is only £890 (£1,000 - £110). Some employees get the value of the employers’ National Insurance savings added to their pension pot too and in this example that would mean that the employee would get an overall pension contribution of £1,128 in return for a real cost of only £890. Not only that, but they wouldn’t be paying tax on the sacrificed salary either and that further reduces the real net cost of the pension provision.
Done carefully this can be tailored for individuals so that they get higher pension contributions without affecting their take-home pay and without costing the employer any more. That can be seen if you think about someone earning £25,000 a year and already paying, say, £100 a month into a personal pension. The net payments into the pension would therefore be £1,200 (12 x £100) and this would be grossed-up to £1,538 to allow for tax-relief at 22% through the net pay scheme that applies to personal pensions. [Another way of looking at this is to say that every £78 invested is grossed-up to £100. The effect of giving tax-relief to pension contributions for standard rate taxpayers is that the contributions made are effectively increased by about 28.21% at the moment they are invested. So in my example here the grossing-up of the £1,200 contribution amounts to £338 (28.21% of £1,200) and gives a total pension investment of £1,538. (In fact, that’s a good short cut you can use when looking at a standard-rate taxpayer’s actual pension contributions if you want to work out what the total amount invested will be once tax-relief is added in; just multiply whatever is paid in by 1.2821.)]
Anyway the take-home pay of this hypothetical person would be £17,417 (£25,000 less the net pension contribution of £1,200 and less tax of £4,172 and also less National Insurance Contributions of £2,211). [The tax is calculated at the 2005/6 tax year rate of £4,895 @ 0%; £2,090 @ 10%; and the remaining £18,015 @ 22%. The National Insurance Contribution is 11% of £20,105 (which is the salary of £25,000 less the Primary Threshold of £4,895).]
So, to sum up, this person has an annual salary of £25,000 and take-home pay of £17,417 and has put aside £1,538 into a pension pot through the magic of the net-pay scheme.
Using salary sacrifice this same person could rearrange their affairs so that their employer reduces their annual salary to, say, £23,200 by ‘sacrificing’ £1,800 of their pay. The deal would be that the employer would put the £1,800 into the employee’s pension pot along with the employer’s NIC savings of 12.8% of the £1,800. So the total pension pot put aside would be £2,030 (£1,800 + 230). The take-home pay now would be £17,411 after tax of £3,776 and National Insurance of £2,013. [The tax is calculated as £4,895 @ 0%; £2,090 @ 10%; and £16,215 @ 22%. The National Insurance Contribution is 11% of £18,305 (the reduced salary of £23,200 less the Primary Threshold of £4,895).]
So, and to sum up again, the same person, but with a reduced salary of £23,200, could end up with take-home pay of £17,411 (practically the same as before) and a pension pot of £2,030 through the magic of the salary sacrifice scheme. This is nearly 32% more than the pension pot provided by the usual net-pay scheme and the person has not lost out on take-home pay and the employer is not out of pocket either. That, of course, is why a lot of people like this idea of sacrificing salary which, on the face of it, seems counter-intuitive.
Now, I know I said that with some careful fine-tuning individuals can arrange things so that their take-home pay is not changed by one penny by ‘sacrificing’ just the right amount of salary each year. In my example here I’ve just gone for some round figures I could punch into my calculator, so I’ve ended up with the two take-home pay figures differing by £6. Financial Advisers will be aware that there are loads of whizzy calculation programs available on-line to help them to get this type of fiddly calculation spot-on, but here I wanted to use easy figures so everyone could see exactly what’s happening and follow the theory. If I’d just put in figures from a web calculator it wouldn’t be so easy to follow I think. But anyway, you get the idea.
It is also possible to arrange things so that the pension contribution made through salary sacrifice is the same as it would be under the net-pay arrangements, but the employee’s take-home pay is actually increased by giving up some salary. The calculations are much as those I’ve just gone through and, again, the whizzy web programs can do the calculations for individuals in the blink of an eye, but this effect too is highly counter-intuitive and takes a fair bit of explaining to people if you get involved in putting these schemes in place.
This idea that people could have their salaries reduced by the amount of their pension contributions and those contributions made to their pension by their employer instead has really caught on in recent years. It has led to a number of large employers offering what have come to be known an ‘Automatic Salary Sacrifice Schemes’. You’ve probably read about these if you’ve nothing better to do at the weekend than read the Sunday papers. What happens here is that instead of salary sacrifice being operated on an individual basis as has been the case in the past some companies now put it in place automatically for all their employees who join their workplace pension schemes. This can even lead to the introduction of new non-contributory pension schemes with the employer paying all of the contributions and employees seemingly paying nothing other than voluntary contributions.
This increase in the spread of salary sacrifice over the last few years has led many to speculate that this is simply a tax loophole that is bound to be closed sooner or later, particularly if more and more companies start getting on the bandwagon. I think that someone said that if all private companies were to do it then the tax guys would lose out on about £1 billion a year*; a fair bit of money. But, as I understand it, it’s not something the Treasury can do much about as their powers only extend to being able to tax what people earn. If people exercise their right to reduce their salaries in return for non-cash benefits that would be something that is covered by employment law, not the tax laws. In fact, the Revenue’s own guidelines on tax avoidance state that in the context of employment, products exempted from disclosure would include: ‘the provision of flexible benefits such as where employees forego salary in return for a car, or are provided with childcare vouchers, salary sacrifice arrangements for cars, computers, childcare vouchers or pension funds’. So, it doesn’t look like the idea could be knocked on the head easily, even if it does become more widespread. One thing you do need to keep an eye on on the tax front, though, is that people are required to inform their local Inspector of Taxes if they sacrifice more than £5,000 p.a..
That’s all very positive, I suppose, but it leads us right back to where I came in on this topic in that while salary sacrifice might be good for employees in general, it’s not necessarily good for some employees as individuals. There are potential losers as well as winners as there are in all other pension decisions that employers take. Because of this I think that employers and their advisers need to make sure that the downsides are given as much airtime as the upside and that really people should be given access to personal financial advice if salary sacrifice schemes are being put in place. To me, therefore, this makes salary sacrifice schemes more difficult when operated on an ‘opt out’ basis rather than an ‘opt-in’ basis and that’s really the reason I decided to write this BeeLine after what the Government guys said a week or so ago about their preference for ‘opt-out’. Employers need to be wary about what the Employment Rights Act 1996 says about unlawful deductions from wages. At the very least, employers need to decide what they will do to accommodate not only those who do not join the salary sacrifice arrangements, but also those who change their minds and want to go back to the higher rate of pay.
Anyway, enough of all that. What about the downsides and the pitfalls? The most obvious I suppose are the ones I came up with on stage when I tried to answer this question in public. Things that are related to pay are obviously going to be affected by effectively earning less. A mortgage application is a good example as are things like overtime rates and shift pay. There’s not much you can do about mortgageability, that’s governed by what you earn and that’s that, but employers can do something about pay-related rates, like overtime, by reference to the pre-sacrifice pay rate in their terms and conditions of employment. It could be set as a base pay of some kind. The same could be done for life assurance and other death-in-service benefits from the pension scheme.
The potential loss of entitlement to State Benefits, though, can’t be dealt with in so tidy a fashion. The biggest issue as I see it relates to the employee’s entitlement to the State Second Pension (or S2P as we trendily call it). Where people are contracted-in to S2P their S2P benefits can be directly reduced by salary sacrifice, but sometimes they’re not, it sort of depends. As usual with everything to do with State Pensions it’s not that easy to generalise about the effects on individuals, but let’s have a go.
First off there are a number of different earnings limits you need to be aware of to understand how S2P entitlements are earned. To start with there is something called the Lower Earnings Limit (or LEL) and for the 2005/6 tax year this is set at £4,264. Next, something I mentioned at the beginning of this BeeLine (seems a long time ago now, doesn’t it?), the Primary Threshold which for the 2005/6 tax year is £4,895. There is also something called the Lower Earnings Threshold, which is set at £12,100 for the 2005/6 tax year. And finally we also have an Upper Earnings Limit (or UEL), which for the 2005/6 tax year is set at £32,760. OK, got all that? Good.
Right then, people who are earning less than the Lower Earnings Limit earn no pension from S2P. Those who earn more than the Lower Earnings Limit, but less than the Primary Threshold, don’t actually pay National Insurance Contributions, but are deemed to be paying them and therefore qualify for S2P benefits. In fact people whose earnings lie between the Lower Earnings Limit and the Lower Earnings Threshold are assumed to have earnings equivalent to the Lower Earnings Threshold for the purposes of calculating their earnings-related S2P benefits. So, someone earning £5,000 a year, say, is treated as though they are earning £12,100 (the 2005/6 Lower Earnings Threshold) when their S2P benefits are calculated. Someone earning £4,300 a year (just above the LEL, but below the Primary Threshold) would get S2P benefits based on presumed earnings of £12,100 for the 2005/6 tax year even though they would not be required to contribute anything through National Insurance Contributions. It is in these ways that the State Second Pension was changed a few years ago to make it more redistributive. S2P now gives more generous pension benefits to lower earners and in some cases can give benefits to non-contributors. There is also a maximum amount of pension that can be earned in any year from the S2P scheme. Earnings above the Upper Earnings Limit (£32,760 in 2005/6) are not taken into account when calculating the earnings-related S2P pension benefits.
So, and to summarise all that insultingly complex twaddle, the position in the 2005/6 tax year is that:
- people earning less than £4,264 a year earn no entitlement to S2P pension benefits
- people earning between £4,264 and £4,895 pay no NIC but get S2P benefits as though they were earning £12,100 a year
- people earning between £4,264 and £12,100 a year get S2P benefits as though they were earning £12,100 a year
- people earning between £12,100 a year and £32,760 a year get earnings-related benefits from the S2P scheme based on their actual earnings
- people earning above £32,760 a year get S2P benefits based on the maximum earnings figure of £32,760.
On top of all that, and to complicate things a bit really, these things aren’t worked out on an annual basis in practice, but a weekly one. So the weekly rates of all the various limits are more relevant in real life and people may earn different S2P entitlements from one week to the next if their weekly earnings fluctuate. I could go into all that here, but life’s too short. Let’s just say that it’s this kind of complexity that ensures bureaucracies thrive and Joe and Josephine Public are kept permanently in the dark about how much pension they’re likely to get. It’s a priesthood thing.
Clearly with the level of S2P benefits earned varying depending on earnings bands, whether or not people sacrificing salary stand to lose out on their Second State Pension rights is also dependent on where their earnings are from time to time in relation to these arbitrary bands too. It would not be a good idea, I think, for someone to sacrifice such an amount of salary that their annual earnings were to fall below the Lower Earnings Limit. That would mean they would not accrue any S2P benefits. However, for people earning above the Lower Earnings Limit of £4,264, but up to the Lower Earnings Threshold of £12,100 salary sacrifice seems to be a great idea as far as S2P benefits go because (as long as they don’t go under the LEL) they will get benefits based on earnings of £12,100 anyway. For example, someone earning £10,000 a year will get S2P benefits based on earnings of £12,100 a year. If they were to sacrifice £1,000 worth of salary and drop to annual earnings of £9,000 instead their S2P benefits would still be based on earnings of £12,100. (In fact, in this particular example the take-home pay on the £9,000 salary would be £330 p.a. higher and the pension pot would be practically the same under the salary sacrifice arrangements as under the net-pay scheme for a net contribution of £1,000 on the higher salary of £10,000. Work it out if you don’t believe me.)
But people earning between £12,100 and the Upper Earnings Limit of £32,760 would lose out on their S2P benefits by sacrificing salary. Given that average earnings in the UK at the moment are around the £25,000 mark it seems likely to me that automatic enrolment into salary sacrifice schemes would give most people plenty to think about. It’s not money for nothing if you’re giving up valuable S2P benefits to get it.
Those earning just above the Upper Earnings Limit would also lose out on some S2P benefits if salary sacrifice took their earnings below the £32,760 level, whereas those comfortably above the UEL stand to gain, particularly if they get the benefit of their employer’s NIC savings added to their pension pots. These people, of course, are the ones most likely to have been attracted to voluntary salary sacrifice schemes on an individual basis in the past.
Other statutory benefits are equally difficult to work out (they come from the same stable, after all), but they are not so widely understood as the State Second Pension benefits are. (That was a joke, by the way.) There are three distinct types of benefit that we’re talking about here; contribution-based benefits; earnings-related benefits (often derived from the amount of National Insurance Contributions that are made); and work-related benefits or payments.
The big three contribution-based benefits are Incapacity Benefit, Jobseeker’s Allowance (contribution-based) and the State Basic Pension. In the case of these benefits it is not a good idea to let your earnings go below the Lower Earnings Limit. The Jobseeker’s Allowance, though, is a funny one as people not paying (or deemed to be paying) enough National Insurance Contributions to qualify for it may still be able to get another version, Job Seeker’s Allowance (income based), which is a means-tested benefit. The Basic State Pension is pretty difficult to explain to anyone who hasn’t got a week or two spare so I won’t be going into all that here except to say if you’re really interested in it you can go and re-read the extensive BeeLine I struggled to put together a few years ago by clicking on the following link. Make sure you’re not alone when you read it though. It’s scary stuff!
Back to basics 1 - The basic state pension
The earnings-related benefits that people can become entitled to are based on their level of earnings, not including any amount sacrificed in return for a National Insurance Contribution exempt benefit. As well as the State Second Pension that I’ve already done to death, the other big benefit of this type is Maternity pay. To get the full entitlement to Statutory Maternity Pay you’ve got to be earning above £4,264 a year (or £82 a week). People with earnings less than this but more than £30 per week will receive a Maternity Allowance, if they earn less than £30 per week they get nothing.
Work-related payments are paid for by employers, but they too are based on a person’s average earnings over a fixed period leading up to when they become payable. Sacrificed salary cannot count towards these benefits. The big two here are Statutory Maternity Pay and Statutory Sick Pay. With Statutory Maternity Pay, once again, dropping below the Lower Earnings Limit knocks it on the head. Earnings above the Lower Earnings Limit count, but the higher rate of benefit (that is paid in the first six weeks of maternity pay) will decrease if you have employed salary sacrifice as it is based on the amount of your cash earnings. Again with Statutory Sick Pay, dropping below the Lower earnings Limit means you get no benefit.
We also have these new tax credits these days, like the Working Tax Credit and the Child Tax Credit. These are aimed at low to middle earning families and the award you get depends on all sorts of things like the number of hours you work, the number of kids you’ve got, whether you’re paying eligible child care costs, what your shoe size is, etc. etc. As far as I can make out it looks like someone receiving these benefits and going for salary sacrifice could end up increasing their awards of credits. But it’s all a bit on the complicated side.
And that’s the point I guess. Clearly if people on low levels of earnings are going to get swept up into automatic salary sacrifice schemes then they will have to watch out for a whole range of unintended consequences on the benefit and credit fronts. These will not be easy for advisers and employers to make sweeping generalisations about and people who could be at risk really should be pointed in the direction of their local benefits office if they’re considering giving up some salary to perform a bit of pension magic. The Jobcentre Plus website might be worth a visit too. People can find that at The Jobcentre Plus.
Anyway, I’ve just realised how dark it is getting outside, so I’ll apologise for having made this such a long read for you. I just got carried away with it. Sorry. I hope you found bits of it some use at least.
Time for a nice cup of tea and a biscuit I think…
28 July 2005
* Source - The Times 23 November 2003
The examples used highlights some of the opportunities for planning, it should be recognised that it is not a complete or exhaustive description of the opportunities or pitfalls.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice.
The details shown are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.
