Salary Sacrifice Pension – how does it work?

Salary sacrifice pension is a way to save on National Insurance Contributions (NIC) for both, employers and employees. NI rates are increasing by an additional 1.25% starting this April and will become a separate H&SC levy in April 2023 that will also apply to employees older than State Pension Age, who are currently exempt from NI contributions.

Considering this, we decided to briefly explain what it is, how it works and what are its advantages and disadvantages. 

What is Salary Sacrifice Pension?

To summarise, a salary sacrifice pension is an agreement between employers and employees to reduce the amount of salary paid to the employee by an amount equal to their pension contribution. In exchange, the employer then agrees to pay the total pension contributions.

Under this agreement, there is no difference for the employer in the total pension contribution (unless the employer increases it as a result of employer NIC saving) and there’s no tax charge for the employee.

Many employees have the right to the salary sacrifice option, but only a small amount of people use it because most employers find it complicated to administer.

What are the advantages?

Employers – The main benefit of using a salary sacrifice pension for employers is reduced employer NI contributions now (and in future the H&SC levy starting on April 2023) on the aggregate amount of the employees’ reduced salaries.    

Employees – Employees benefit from a salary sacrifice pension in several ways. Firstly, by reducing their salary, they will no longer pay NI contributions or the future H&SC levy on the amount exchanged. 

Secondly, under this scheme, all pension contributions payments are treated as employer only and therefore the employees receive the equivalent of their full tax relief each month. 

Usually, employee contributions operate on a ‘Relief at Source’ tax relief basis. Under this agreement, 80% of the gross contribution is deducted from the employee’s net pay. Basic rate relief of 20% is then added to the pension by HMRC, irrespective of the employee’s income tax rate. This means that the basic rate tax-payers will obtain the full tax relief, but it’s more complicated for higher rate tax-payers. They are eligible for further tax relief but usually experience delays as they need to claim further tax reliefs by self-assessment return or by altering their tax code with HMRC.

What are the disadvantages?

Despite the benefits, the salary sacrifice pension process is rather complicated. It needs to be correctly structured or HMRC can challenge the arrangement. If you decide that this is an option for your organisation, here are several considerations that might help you along the way:

• A voluntary vs a wholesale agreement (including any contractual changes).
• Employees receiving minimum wage are not eligible for salary sacrifice pension, therefore, some employees may need to be excluded and earnings to be monitored.
• HMRC allows employees to cancel the agreement or reduce their sacrifice pension only after 12 months (except if they experience one of a defined list of lifestyle events).
• A lower salary may result in lower group risk insurance benefits so some organisations may need to consider adapting other policies such as Group life or Group income protection.
• Decision on whether to retain or rebate all or part of the employer NIC savings (relating to the bonus if the employer uses NIC saving for that)
• Any other communications issues that might arise in the contract wording or employees’ responsibilities.

A correctly done salary sacrifice pension is a great way save on NI contributions for both the employer and employee and helps higher rate tax-payers to claim additional pension tax relief. Considering NI rates increasing in April and continuing to increase with the new H&SC levy next year, the salary sacrifice pension contribution can be an attractive option for many organisations. However, we strongly recommend seeking professional advice on any variation to employee contracts and the different rules that apply to this rather complicated process.