Pension Salary Sacrifice vs Non-Salary Sacrifice

Pension contributions can be structured in more than one way, and the difference between salary sacrifice and non-salary sacrifice arrangements is one that every UK employer should understand. The two approaches produce the same end result for employees in terms of pension savings, but the tax and National Insurance implications are quite different.

Salary sacrifice, sometimes called salary exchange (it is the same thing), is an arrangement where an employee agrees to give up a portion of their gross salary in exchange for an equivalent employer pension contribution. Because the contribution comes from the employer rather than the employee, both parties pay less National Insurance.

For the employee, the reduction in gross salary means they pay less income tax and National Insurance on their earnings. For the employer, lower employee gross salaries mean lower employer National Insurance contributions as well. In most cases, these employer NI savings are significant enough to offset the cost of the arrangement and, in many instances, produce a net saving.

In a non-salary sacrifice arrangement, the employee usually makes their pension contribution directly from their net pay, through the relief at source arrangement. The employer makes their contribution separately. There is no reduction in gross salary, which means neither party benefits from the National Insurance saving that salary sacrifice provides.

Non-salary sacrifice arrangements are simpler to set up and require less contractual administration, which is why some smaller employers default to them. However, they are almost always less tax-efficient for both employer and employee.

For the majority of employers, salary sacrifice is the more advantageous arrangement once the administrative setup is complete. The employer NI savings alone can be substantial across a workforce, and many businesses use a proportion of those savings to enhance their overall pension contribution or invest in other employee benefits.

That said, salary sacrifice is not always appropriate for every employee. Where it would reduce an employee's salary below the National Minimum Wage, it cannot be used. Employers also need to ensure employment contracts are updated correctly to reflect the arrangement, as it constitutes a change to the terms of employment.

Best practice is to keep a record of the pre salary sacrifice salary, sometimes referred to as a reference salary. All salary linked benefits should be worked out using the reference salary and not the lower salary sacrifice amount. Mortgage lenders, for example, used to assess borrowing capacity based on gross salary. For any type of lending where this is the case, if a contract shows a lower gross salary as a result of salary sacrifice, this can affect their ability to borrow. However, these days mortgage lenders are more concerned about affordability and because salary sacrifice can lead to a higher taken home salary, it could have the effect of slightly increasing the amount that can be borrowed. It is best practice for life assurance benefits calculated as a multiple of salary to be based on the pre salary sacrifice reference salary as well.

We have found that it is important to particularly communicate this to employees clearly before implementation, so they can make informed decisions.

Before communicating to your employees it is worth holding a session with line managers so that they have time to understand the benefit of salary exchange. They are bound to be asked whether this is a good thing and it is wise to avoid miss-understandings and to get them onboard. We find holding a briefing presentation to them just before launch to be a great influence in making the implementation successful.

If your business is currently operating a non-salary sacrifice pension arrangement and you are considering making the change, the process involves updating contracts, notifying employees, and liaising with your pension provider. Done correctly, it is a manageable process with meaningful ongoing financial benefits.

Our auto enrolment compliance service covers both the setup and the ongoing management of workplace pension arrangements, including salary sacrifice structures. If you would like to understand whether a switch makes sense for your business, we are happy to talk it through. Get in touch with HWWA Consulting today.