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Karl Vernum of Chiltern asks why an employee might give up part of their salary or bonus, and why the sacrifice might be worth it. 

Introduction

Salary sacrifice is an arrangement between employee and employer that allows part of a salary, or bonus, to be given up in exchange for a non-cash benefit. This is not a new concept; it has been around for some time.

Salary sacrifice has grown in popularity as employers strive to provide, restructure or establish the best pension provision for staff at a reasonable cost.

The question is why an employee would give up part of his salary, or bonus, for a non-cash benefit such as a pension contribution. Why is the sacrifice worth it?

First, less salary means less income tax and national insurance contributions for the employee.

Second, the pension contribution following a salary sacrifice arrangement comes from the employer instead of the employee. Employers do not pay NI on contributions to a pension arrangement on behalf of employees. Therefore, the employer makes savings as well as the employee.

Example

An employee has been working for his employer for a number of years.  His employer has mentioned that there is a way by which even more money can be put into the scheme without any additional cost to him.

In fact, it might even save him money.

Assumptions

The salary sacrifice is concluded in the 2007/2008 tax year. It shows that the employee has an annual salary of £25,000. He pays £1,000 gross into the pension scheme, or 4 per cent of his salary, each year.

Net of tax relief, this costs £780 a year. He pays £4,082.90 a year in income tax and £2,178 in NI, leaving him with an annual take-home pay of £17,959.10.
 
Correspondence from the employer suggests that take-home pay could be higher if, instead of the employee paying the pension contribution, he sacrifices part of his wage and lets his employer pay into the scheme.

If the employee chooses this option, his annual take-home pay will increase to £18,069.10, just more than £100 higher. The employer has mentioned that it will save money on the company's NI contributions, and will add this saving to his £1,000 sacrifice, giving him an annual pension contribution of £1,128.

By sacrificing £1,000 of salary for the company pension scheme, the employee has increased his take-home pay and the amount being paid to his personal retirement pot. From the employer's perspective, the sacrifice is cost-neutral, but it has helped the employee to pay more money into his pension.

Even if the employer decided against contributing its NI saving to the employee’s pension - perhaps in order to save money - he would still be better off.

Implementation

To be effective, salary sacrifice has to result in a change in the contract of employment, to reflect the reduced salary and non-cash benefit - the pension contribution. This needs to be done in writing before the salary is actually paid.

It is also important to note that employees cannot retain the right to revert to the higher salary - if they did, the sacrifice would be ineffective.

It must also be noted that reducing salary can have an effect on other benefits, both from an employer and from the state such as Child Tax Credits, Statutory Sick Pay (SSP) and Statutory Maternity Pay (SMP).

Calculation

An employer considering setting up, or allowing employees to set up, a salary sacrifice arrangement needs to be clear about the effect this will have on, for example, overtime rates and shift allowances, redundancy pay and death benefits provided by the company.
In its calculation, it is normal for the employer to use a notional basic salary that includes the sacrificed amount.

This is an area in which an employer can have influence - such as ensuring that staff are not worse off. State benefits, however, are a different story.

Choosing to take a reduced salary may affect many state benefits, including the basic state pension, the earnings-related state second pension, incapacity benefit and jobseeker's allowance.

Rule changes

It is possible for employees to sacrifice a bonus and have it paid as an employer contribution to their pension pot. If a bonus is contractual, the same rules apply as for a salary sacrifice, and it is a change to the contract of employment and needs to be agreed in writing before the bonus is paid. The current rules make it easier for employees to sacrifice a bonus payment.

Post A-Day, there is no restriction on how much an employer can pay to an employee pension scheme. Tax charges do apply in a year when contributions by, or on behalf of, an employee exceed the annual allowance - £225,000 in the 2007/2008 tax year - or when benefits not subject to transitional protection exceed the lifetime allowance.

Bonuses are usually relative to an employee's salary, and as such an employee should be able to sacrifice a bonus and have his company pay it as a pension contribution without breaching the post A-Day "wholly and exclusively" rules.

The pre-A-Day percentage of earnings scale was not as flexible, restricting contributions to a personal pension to between 17.5 per cent and 40 per cent of earnings depending on age as of 6 April in the relevant tax year. This limit included any employer contributions paid.

So, is salary sacrifice worth it? Depending on the personal circumstances of those involved, it is worth considering.

And undoubtedly for some, a salary or bonus sacrifice will be extremely attractive. There are, however, pitfalls, and care needs to be taken to ensure that those who opt for salary sacrifice understand it, know how it affects them, and are able to make an informed decision.

Employers looking to make use of salary sacrifice in pension arrangements should ensure that they, together with their financial advisers, provide employees with access to the information needed to make the right decision.

Employees looking to use salary sacrifice who are at all unsure about how it will affect them, should seek professional advice.

This article first appeared in Payroll and Human Resources (September 2007), and is reproduced with the kind permission of Chiltern.