How can employers and employees increase their pension contributions as purse strings are tightened?
It has become common practice for employees to exchange part of their salary and/or bonus in return for their employer paying the exchanged amount as an employer pension contribution.
This is commonly known as salary or bonus ‘sacrifice’, but I prefer to use the term ‘salary exchange’. That is because with this system you are getting something back for the exchange, whereas ‘sacrifice’ sounds like you are giving something up.
Bonus and salary exchange are often more attractive propositions than an employee making a direct pension contribution – particularly if the employer increases their pension contribution by part, or all of, any saving on national insurance contributions. Employers can also use salary/bonus exchange to increase take-home pay.
But what are the potential advantages – and drawbacks – of salary exchange?
How salary and bonus exchange work
Salary or bonus exchange requires an employee to agree to change their terms and conditions of employment relating to pay.
Under their revised contract, the employee gives up some of their salary, or contractual bonus, in return for a non-cash benefit from the employer, for example, an employer pension contribution.
As the salary is being exchanged rather than paid, neither the employee nor employer pay NICs on the exchanged amount. Normally, this is done to create income tax or NI savings without reducing the overall value of an individual's benefit package.
The employer can then pay the exchanged amount into the employee’s pension plan as an ‘employer contribution’.
Why use salary exchange for pension funding?
If an employee pays pension contributions out of their salary after tax, they will have already paid NI on their gross income, and so will their employer.
A salary or bonus exchange arrangement will first and foremost help fund a pension. However, at a time when everyone is counting the pennies – businesses and individuals alike – it can also save both the employee and employer a significant amount of money.
In the "mini" Budget on September 22 2022, the chancellor of the exchequer announced that the health and social care levy will no longer go ahead. From November 6 2022, the temporary 1.25 per cent increase in NI rates for employees and employers is being reversed for the rest of the financial year.
The introduction of a separate health and social care levy tax in April 2023 has been cancelled.
Even though the additional 1.25 per cent NI has been removed, salary exchange can still be very beneficial.
How the employee benefits
Exchanging salary for pension contributions will reduce the employee’s earnings. That usually means the employee will pay less income tax and NI than before.