Salary sacrifice is something of a buzzword amongst employers these days, especially after the rise in National Insurance rates in April 2003. In this article Eamonn O’Connor, from Gissings Consultancy Services, discusses the benefits of salary sacrifice for pension arrangements
Perhaps it’s merely a coincidence, but interest in salary sacrifice schemes among employers has picked up since the Inland Revenue (IR) raised National Insurance rates in April 2003. The IR also issued clarification in February 2003, wherein they said they do not view employers who set up such a scheme as tax evaders. Combine those factors with a more challenging economic environment and it’s no wonder salary sacrifice has appeared on many employers’ radar screens.
What is salary sacrifice?
As defined by the IR, salary sacrifice means an employee agrees to give up the right to receive part of their cash compensation, in return for an employer agreement to provide some kind of non-cash benefit instead. Often this employer provision can be a pension payment, but it could also be a payment toward childcare assistance, for example. For the purposes of this article, we will discuss salary sacrifice as it relates to pension arrangements.
The basic requirements to set up a salary sacrifice scheme are:
- It should be evidenced in writing.
- It should demonstrate an agreement (not instruction) by both employer and employee.
- It should document separately that an employer will make a contribution to the pension scheme.
- It should be effective before the employee is legally entitled to the remuneration.
- Any salary sacrifice of £5,000 or more in a tax year (per individual) must be reported to the local Inspector of Taxes.
Given those basic stipulations, it may seem like a complicated undertaking and in many ways it is. So why would an employer jump through all the IR hoops to establish such a scheme? For starters, a scheme that meets all the IR requirements will plainly and simply save on National Insurance contributions (NICs).
It’s hard to argue with that, but how does the savings work exactly?
Any employer who makes a contribution to an employee’s pension is able to save on National Insurance. When an employer makes a contribution to an employee’s pension scheme under a salary sacrifice arrangement, that contribution is in essence an employer contribution and thus exempt from NIC.
No brainer then...
Well yes. One could argue that the only reason for employers to maintain a pension scheme structure, where there are employee contributions, is quite likely to be inertia.
If it is so simple why aren’t there more salary sacrifice schemes around? What’s the hitch?
Great care must be taken in setting up a salary sacrifice scheme, and considerable effort and time can be expended by the employer at their risk.
How so?
While the IR recognises that employees may want to give up some rights to salary, in exchange for additional payments into a pension, they will not approve the arrangement until the scheme has been established. Employers should take care not to be seen as orchestrating a mass salary sacrifice programme or swapping NIC taxable benefits for non-taxable benefits and specifically organising things to avoid NIC.
What can employers do to keep the Revenue happy?
The Revenue is very clear on several points. If the salary sacrifice pension arrangement is to be used to reduce NIC payments on the amounts sacrificed, the employee has to agree to give up the right to this portion of his salary. The change is also irreversible. That is, it cannot be unilaterally rescinded by the employee. Setting up a salary sacrifice scheme is a change to terms and conditions.
It’s starting to sound complicated...
It can be. There are disadvantages to establishing a salary sacrifice scheme, as opposed to offering a pension scheme as part of a flexible benefits programme. Salary sacrifice schemes require an exchange of documents between employer and employee, where the employee agrees to a reduction in salary and the employer agrees to pay this amount toward a pension arrangement. This agreement must be reached with each employee.
Any flexible benefits programme is, in effect, a form of salary sacrifice or more accurately remuneration sacrifice. The difference, however, is that with a flexible benefits scheme, the agreement between employer and employee is built into the administration of the flexible benefits programme from the outset. The employee agrees to a certain level of remuneration and a flexible benefits pot, from which they can choose to spend on benefits as they wish. From this point onward, all of the money contributed toward these benefits is, in essence, an employer contribution.
Can any kind of pension scheme become a salary sacrifice scheme?
Yes. Although more popular with money purchase arrangements, employers can turn a defined benefit scheme into a salary sacrifice scheme. However, it can be more complicated.
What other things do employers need to consider?
The employer would need to give careful consideration before incorporating an existing company scheme into a salary sacrifice arrangement. Often schemes have a two-year vesting period so that members are not entitled to a benefit, other than a refund of these contributions, if they leave within two years. Vesting periods do not sit comfortably with these rules – why would an employee elect to make pensions contributions, rather than receive cash, if they might lose the benefit by leaving within two years?
Sounds like quite a few advantages for the employer, what about employees?
There are some. Those employees who want to make high levels of pensions contributions as they near retirement stand to benefit the most, as payments to the pension fund are made by the employer and, therefore, do not count against the 15 per cent earnings limit for occupational schemes.
It is important to note, however, that salary sacrifice permanently reduces salary and may impact on scheme benefits for those very close to retirement. Additionally, it could have a negative effect on mortgage lending, state benefits, and S2P, where calculations would take lower salary into account.
In contrast, with flexible benefits, we’ve found the notion of reference salary is stronger, even if the employee overspends their flexible benefits account. The concept of total remuneration is fairly well-established with flex.
How does a pensions only salary sacrifice scheme compare to pensions offered via flexible benefits?
Both routes constitute permanent changes to contracts and conditions of employment. Confusion between the two arises in that there is a IR and tax angle, as well as employment contract angle. Outlook
As many are already aware, the IR rules on NIC savings could change. We have yet to see any hard evidence that employers are flocking to salary sacrifice arrangements for many of the reasons we discussed. Could a decrease in the amount of NIC revenue trigger a change of heart by the IR? It’s hard to second guess the IR, but it would be a stretch to say salary sacrifice schemes or pensions schemes run as part of a flexible benefits programme have decreased the IR’s coffers.
Pure economic factors, such as a declining equity market and their impact on pension schemes, are more likely to be the culprit as employers are having to contribute more to their schemes where in years past, they perhaps took a contributions holiday. As employers make up for falling market prices in increased contributions toward their pension schemes, that by extension means less IR takings.
Eamonn O’Connor, managing director, Gissings Consultancy Services Limited. Finsbury House, 23 Finsbury Circus, London, EC2M 7UH. Tel: 020 7628 9899. Web: www.gissings.com
(This article was originally published in Director of Finance 2004 edition)
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