Salary sacrifice for pension purposes has always been popular; it combines a valuable, tax-efficient employee benefit as well as a cost saving for employers. With this in mind auto enrolment should make salary sacrifice even more popular, as cost savings could help meet employer’s cost of implementing and administering the scheme. However, the Workplace Pensions legislation imposes certain requirements that an employer must be aware of.
This factsheet will tell you what you need to know about salary sacrifice. It will also explore some of the areas an employer should consider if they’re thinking about using salary sacrifice for their pension scheme.
A salary sacrifice arrangement (salary exchange) is an agreement between an employer and an employee to change the terms of the employment contract to reduce the employee’s entitlement to cash pay. This sacrifice of cash entitlement is usually made in return for some form of non-cash benefit i.e. pension contributions etc.
If this happens, the employee gives up part of their salary and the employer pays this straight into the pension. In many cases the employer will take the amount that they save on employer’s NIC and pay this into the pension, thereby increasing the employee’s pension pot. Although employers may now decide to put any savings made towards the implementation and administration costs of auto enrolment.
Where salary sacrifice is being used, there will only be an employer’s contribution. The employee’s deduction is zero.
Both the employer and employee should consider certain factors before agreeing to a salary sacrifice.
A reduction in salary will impact on the level of income tax and NIC the employee will pay, however it will also impact on:
Employers should also note that earnings must not fall below the National Minimum Wage as a result of salary exchange.
Employers offering salary sacrifice should provide clear communication to workers explaining what salary exchange is, how it works, and the benefits it brings.
Introducing salary sacrifice in conjunction with auto-enrolment raises challenges for employers. If, prior to auto enrolment, an employer offered pensions through salary sacrifice, they will need to review their current operation to ensure they meet the new auto-enrolment duties.
Auto enrolment requires that employees are automatically enrolled and then given the option to opt out. Salary sacrifice, on the other-hand, is a voluntary reduction to the employee’s contractual pay. HMRC has made it clear that an employer must document and agree a salary sacrifice arrangement with each employee before it takes place. As salary sacrifice arrangements go against the automatic entitlement to be enrolled, making salary sacrifice a condition for enrolment into the pension scheme will not be permitted.
Secondly, if the employer is using qualifying earnings as the basis to calculate contributions, a reduction in salary will mean a lower basis on which to base minimum contributions. Alternatively, if contributions are based on pensionable pay, the scheme rules wil determine the contribution basis.
Automatically enrolled jobholders have the choice to opt out of the pension scheme within one month. This means that where a salary exchange arrangement has been used with automatic enrolment, the jobholder’s salary should be returned to its previously higher level. Fortunately, a relaxation of the previous HMRC rules means that employers can revoke a salary exchange arrangement and return the jobholder’s salary to its previously higher level without having to wait one year to do so.
As seen above, there are a number of issues for employers considering using salary exchange with auto enrolment. The key to operating salary sacrifice alongside auto enrolment is to document the sacrifice agreement in a way which allows the employer to comply with its auto-enrolment duties. There may not be one right answer but an employer contemplating salary exchange at its staging date might consider:
A. Using the postponement period
Employers can choose to postpone their auto-enrolment duties for up to three months. They can then use this period to get employees’ agreement to join on a salary sacrifice basis.
All those agreeing to join during that period will, at the end of the postponement period, be classed as active members of a qualifying scheme.
All those who do not join will, at the end of the postponement period, need to be assessed to find out what category of worker they fall into, then auto-enrolled if they are classed as eligible jobholders. This will not be on a salary sacrifice basis, meaning the scheme would end up with a mixture of jobholders using salary sacrifice and those who aren’t.
B. Making it the default position to auto enrol without salary exchange but offer salary sacrifice at the same time.
Employers can ask workers if they want to put in place a salary exchange agreement but they must do this before the workers' auto enrolment date.
From an administrative point of view, this approach could prove time consuming and cumbersome. Employers would have to give the employee two sample calculations, the first assuming that salary sacrifice does not apply and the second assuming that it does. Unlike auto-enrolment, employees would then have to proactively choose salary sacrifice.
C. Offering salary sacrifice after auto-enrolment
Auto enrol all eligible jobholders first, allowing sufficient time for any opt outs to be processed, and then offer salary sacrifice at a later date.
D. Making salary sacrifice contractual
Employers may choose to contractually join their employees into a qualifying scheme, instead of using an auto-enrolment scheme. Under this option salary sacrifice would be included in the contract of employment. By signing the contract of employment, employees agree to salary exchange, so there would be no conflict with the auto-enrolment process.
Salary sacrifice should be set up before the employer’s staging date. If not, the employer’s auto-enrolment duties will kick in at their staging date. Assuming contractual contribution rates are high enough, everyone contractually joined will be classed as active members of a qualifying scheme at the staging date.This means there will be no need to assess the workforce as everyone is already in a qualifying scheme.
For new employees this is likely to be relatively straight forward. However, for existing employees it could be difficult to retrospectively change contracts of employment. This could also open up the employer to more general contractual negotiations, completely unrelated to salary sacrifice.
Drafting salary exchange into a contract of employment requires considerable thought. A sample contract clause can be found here, however users should take care to revise and ensure that it suits their own particular needs.
Once a decision has been made to operate a salary sacrifice scheme and in which manner that will be done(A to C above), consideration should turn to how the salary sacrifice should be put in place.
A salary sacrifice agreement will be deemed effective by HMRC if the salary sacrifice agreement is in writing, is dated, and signed by both employer and employee.
The agreement must make clear that the salary sacrifice has affected the employees rights to remuneration – it must state that the employee is now entitled to a lower cash remuneration plus a benefit instead.
To assist employers, a draft salary sacrifice agreement for pension purposes is provided. Click here.
There is no obligation on employers to inform HMRC that salary sacrifice has been set up. However, many employers will do so for reassurance that they are calculating the correct amount of income tax and NI.
Many, but not all AE schemes accept salary sacrifice. Of those that do accept salary sacrifice, some apply specific terms and conditions, which may or may not restrict some of the options outlined above. For employers, it will be important to check with your proposed pension provider before making any decisions.
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