Pension salary sacrifice is a method of saving National Insurance Contributions (NIC) for employers and employees, yet only 50% of organisations use it. With NIC rates increasing by an additional 1.25% this April, there’s now a stronger case for employers to consider it.

What is it?

Pension salary sacrifice, or more accurately salary exchange, is the contractual agreement between an employer and an employee to a reduction in salary, in exchange for an employer pension contribution of at least the same amount.

How does it work?

Employer-paid pension contributions are not a taxable benefit. Therefore, an employee who’s currently paying employee contributions into a pension, could instead, agree to ‘swap’ the amount of salary equivalent to their gross contribution on condition that the employer pays this as an employer pension contribution. 

Under a correctly structured agreement, there is no difference in the total pension contribution made on the employee’s behalf (although the employer can decide to increase it by adding some, or all, of the resulting employer NIC saving) and there’s no tax charge for the employee. 

Advantages for the employee

Reduced NIC

Taking the example above, by reducing their salary, the employee will no longer pay NIC (or the future Health and Social Care levy) on the amount of salary they exchange. So, in comparison to their previous position, they’ll experience an increase in net pay, as they now pay less NIC. From April 2022 the saving in NIC (and the subsequent H&SC levy) will be between 13.25% and 3.25% of the sacrificed amount, depending on earnings (see table below).

Full and immediate tax relief for higher rate tax-payers

Employee contributions into contract-based pension schemes, which include Group Personal Pensions, operate on a ‘Relief at Source’ tax relief basis. Under this arrangement, 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. 

Therefore, basic rate tax-payers automatically obtain full tax relief, but it’s not as simple for higher rate tax-payers. They’re eligible for further tax relief which can be claimed through their self-assessment return or by altering their tax code with HMRC. Normally this means there’s a delay in obtaining the relief, and they face the burden of completing a tax return, sometimes solely to claim the rebate. 

Under salary sacrifice, there are no employee pension contributions as all payments become employer contributions. As such, this issue doesn’t arise. Every employee receives the equivalent of their full tax relief each month. 

It’s important to note that trust-based pension schemes, which include Master Trusts like NEST, can operate on a ‘Net Pay’ basis. This method applies full pension tax relief through the payroll, so the advantage of salary exchange for these members is solely the saving in employee NIC.

Advantages for the employer 

Reduced employer NIC

The key benefit is the saving in employer NIC (and the future H&SC levy) on the aggregate amount of the employees’ reduced salaries.    

For example, consider an employer with 25 employees, an average salary of £35,000 p.a., and each employee contributing 5% gross into the pension i.e., a total gross employee pension contribution of £43,750 p.a. 

If all employees made their contributions via salary sacrifice, the employer would save over £6,500 per year in NIC (based on the Employer NIC rate of 15.05% applicable from April 2022 - see table below). 

What’s happening to NIC rates?

Employer and employee NIC rates will increase by 1.25% from April 2022. In April 2023, NIC rates will return to the current levels and the 1.25% increase will, instead, become a separate H&SC levy. This levy will also apply to employees older than State Pension Age who are currently exempt from NIC.

*Earnings thresholds for 21/22, these may change in the future.

Why does pension salary sacrifice work?

A correctly structured arrangement works because employer pension contributions are excluded from the Optional Remuneration Arrangement ‘OpRA’ legislation (April 2017). This legislation restricts the NIC advantages of many other salary sacrifice benefits.

What needs to be considered?

Salary sacrifice involves more than a one-page form. It needs to be correctly structured or HMRC can challenge the arrangement and the NIC savings. We recommend professional advice on the drafting of the rules and agreements, and on the variation to employment contracts. There are a number of considerations, which include:

• Whether to establish a voluntary arrangement, or a wholesale change to all employee contracts. The latter usually results in a higher take-up and less ongoing administration, but the contractual change needs careful consideration.

• Whether to retain or rebate all or part of the employer NIC saving. Some employers use a proportion of the employer NIC saving to add a ‘bonus’ to pension contributions above the enrolment requirement.

•  Employees cannot sacrifice their salary below the statutory living/ minimum wage, so you may need to set the eligibility rules accordingly, exclude some employees and monitor earnings.

• It must be a genuine contractual change. Depending on how the agreement is worded, this could mean that an employee is entitled to the employer contribution amount even if their salary reduces during a statutory absence. Careful wording can prevent this outcome.

• Employees can’t join and leave whenever they want. HMRC allows employees to cancel the agreement or reduce their sacrifice after 12 months, or at any time if they experience one of a defined list of lifestyle events. 

• A lower salary may result in lower group risk insurance benefits linked to salary (e.g. Group life, Group income protection). So, you may need to consider adapting these policies. 

• There are associated issues, such as making it clear that employees are responsible if they exceed the Pension Annual Allowance and/or Lifetime Allowance. 

Summary 

A correctly structured pension salary sacrifice is fully accepted by HMRC. It provides material NIC savings for both the employer and employee, and it removes the need for some higher rate tax-payers to claim additional pension tax relief. The case for employers, particularly those with relatively well-paid employees, to consider an arrangement has always been strong. With NIC rates increasing, and the increases continuing as the new H&SC levy, that case is even stronger.