SALARY EXCHANGE ADVISER GUIDE This material is for use by UK Financial Advisers only. It is not intended for onward transmission to private customers and should not be relied upon by any other person.
INTRODUCTION THE PENSION ENVIRONMENT IS EVOLVING. GONE ARE THE DAYS WHERE A STANDARD APPROACH TO SAVING FOR RETIREMENT WAS THE ONLY OPTION. NOWADAYS WE CAN SEE EMPLOYER S PENSION SCHEMES WITH DISCOUNTS, THEIR OWN SPECIALLY SELECTED DEFAULT FUNDS AND SELF-INVESTMENT OPTIONS. There are various options which can be tailored to suit the needs of the employer, to make their scheme cost effective and attractive. Salary exchange (also known as salary sacrifice) is one of those options. This guide explains how it works, who it s suitable for and how it can benefit both the employer and employee. With automatic enrolment now well underway, salary exchange is likely to become more popular as employers look to use their National Insurance Contributions savings to help offset the increased pensions costs associated with Automatic Enrolment. WHAT IS SALARY EXCHANGE? Salary exchange is an arrangement where an employee gives up the right to part of their future earnings or bonus in exchange for a non-cash benefit. As part of the salary is being exchanged rather than paid neither the employee or the employer pay National Insurance Contributions (NICs) on the exchanged amount. Some of the benefits could include: increased pension for employees increased take home pay for employees adding value to the benefits package reduced costs for employer. HOW DOES SALARY EXCHANGE WORK? The employee decides how much they want to exchange and their salary is reduced by this amount. The exchanged amount can then be paid to the employee s pension plan as an employer contribution. The exchanged amount will therefore be included in any employer contribution shown in our illustrations and annual statements. 1
SETTING UP A SALARY EXCHANGE ARRANGEMENT The exchange is achieved by altering the employee s terms and conditions of employment. It can be set up at any point but the salary exchange agreement must be in place before the salary is actually exchanged to meet the HM Revenue & Customs (HMRC) guidelines. HMRC also state in their guidance that they require full details of the scheme and of the new contractual arrangements. The full set of guidelines can be found at www.gov.uk/salary-sacrifice-and-the-effects-on-paye Note: Salary exchange is considered a matter of employment law, not tax law. WHAT ABOUT SMART PENSION SCHEMES? The basic principle of the employee giving up part of their salary in exchange for a non-cash benefit doesn t change with a smart pensions scheme; but the sign up method is different. Rather than obtaining separate agreement from each employee to go ahead with their exchange, smart pension schemes instead rely on employees who do not wish to participate to opt out of the proposed exchange. Employers would communicate to their work force, advising them that the proposed salary exchange will take effect from a specified date (this date must be in the future). Any employees who do not wish to take part must actively opt-out. The employer must ensure that employees are given plenty of time to make their decision. Scottish Widows recommend a minimum of 4-8 weeks notice. The automatic enrolment legislation does not permit employers to make salary exchange a condition of enrolment into the scheme. However, it is possible to amend employees contracts to make it a condition of their employment that contributions are made via salary exchange. There are other ways an automatically enrolled scheme can use salary exchange. These include: Enrol members into the scheme and then offer them the opportunity to contribute via salary exchange. Enrol members into the scheme and offer them the opportunity to contribute via salary exchange at the same time. WHERE CAN SALARY EXCHANGE BE USED? In order for salary exchange to be considered, a pension scheme which can accept employer contributions must be in place. Salary exchange can be used with: an occupational money purchase scheme a group personal pension (and personal pension) a group stakeholder pension (and individual stakeholder pension) an executive pension plan. CHANGE TO CONTRACT OF EMPLOYMENT To set up salary exchange, the employee s contract of employment must be changed and this should be formally agreed between the employee and the employer, for example in a letter. A copy of this agreement letter should be kept with the employees original contract of employment. It is essential that the agreement is in place before the salary is exchanged, and well in advance of the first payment. For Smart Pension schemes, HMRC is satisfied that as long as the revised terms and conditions of employment are communicated to employees in advance of the salary exchange arrangement being introduced, then employees who do not opt out are accepting the variation to their employment contract. For contract based schemes, it should be noted that there may be additional contract and/or employment law considerations. Where employers intend to implement a salary exchange arrangement without obtaining the employees explicit consent, we strongly recommend that legal advice is sought before any change is made. It is up to the employer to specify the length of time the arrangement will last for (this is usually a 12 month period). The employer may wish to include the option to change the arrangement if an employee were to experience a lifestyle change. The employer should define the lifestyle changes applicable to the arrangement. Following the introduction of automatic enrolment, HMRC have confirmed that it is permissible for a salary exchange arrangement for a workplace pension scheme to be changed on request, and now they don t insist on the exchange being for a set period or for lifestyle changes to be specified. 2
SETTING-UP THE ARRANGEMENT The employer can set up the arrangement in a number of ways, however reinvesting the employer NIC savings will give the employee the most benefit and may encourage scheme take-up. In this guide we ll look at the 4 main options. The scenarios below assume an employer provides a Group Personal Pension (GPP) arrangement. The employee earns 25,000 a year with both the employer and the employee currently paying a contribution of 5% of gross salary. The examples show the different ways salary exchange works if the employee percentage is no longer paid by the employee but is exchanged and paid direct by the employer. Option 1 (employer and employee NIC reinvestment) Employer costs stay the same, employee s take home pay stays the same and the pension contribution increases. With this option, the position remains cost neutral for both parties and all the employer s and employee s NIC savings are reinvested into the pension scheme so the overall contributions are increased. OPTION 1 Before Exchange After Exchange Benefit Employer position Total cost (salary, pension & NICs) 28,573.37 28,573.37 0.00 Employee position Take home pay 19,279.68 19,279.68 0.00 Total gross pension contributions 2,500 2,923.53 423.53 Option 2 (only employer NIC reinvestment) Employer costs stay the same, the employee s take home pay increases and the pension contribution increases. In this option, only the employer s NIC saving is reinvested, resulting in a higher pension contribution. The employee s take home pay increases as they are paying less NICs on a reduced salary. OPTION 2 Before Exchange After Exchange Benefit Employer position Total cost (salary, pension & NICs) 28,573.37 28,573.37 0.00 Employee position Take home pay 19,279.68 19,429.68 150.00 Total gross pension contributions 2,500 2,672.50 172.50 Option 3 (no employer NIC reinvestment) Employer s costs reduce, the employee s take home pay increases and pension contributions remain at same level. With this option, none of the employer s or employee s NIC savings are reinvested in the pension scheme, but the employee pays less NICS on a reduced salary, which increases their take home net pay. OPTION 3 Before Exchange After Exchange Benefit Employer position Total cost (salary, pension & NICs) 28,573.37 28,400.87 172.50 Employee position Take home pay 19,279.68 19,429.68 150.00 Total gross pension contributions 2,500 2,500 0.00 3
Option 4 (no employer NIC reinvestment) Employer s costs reduce, the employee s take home pay stays the same and pension contributions increase. With this option, the employee sacrifices a slightly higher amount to produce exactly the same take home pay. Because they ve exchanged slightly more, their pension contribution increases. In this example none of the employer s NIC savings are reinvested. OPTION 4 Before Exchange After Exchange Benefit Employer position Total cost (salary, pension & NICs) 28,573.37 28,370.43 202.94 Employee position Take home pay 19,279.68 19,279.68 0.00 Total gross pension contributions 2,500 2,720.59 220.59 The figures are based on tax and NI for 2017/18 tax year and a single person s allowance of 11,500. The value of the tax benefits of a pension plan depend on an individual s circumstances. These circumstances and tax rules may change in the future. Our salary exchange tool can be requested through your Scottish Widows Account Manager, the tool will allow you to calculate real examples for individuals and group schemes. OPTIONS AT A GLANCE Options Employer costs Employee take home pay Pension Contribution Summary 1 no 2 no 3 decrease 4 decrease change no change increase change increase increase increase no change no change increase This is cost neutral. Employer NIC saving is reinvested Employee sacrifices slightly higher amount to keep their take home pay at the same level so pension contributions are increased. Employer NIC saving is reinvested Employee does not have to pay NIC on the amount sacrificed, so this increases their take home pay. Employer no reinvestment of NIC savings Employee as salary is reduced, the amount of NIC paid is also lower, so this increases their take home pay. Employer no reinvestment of NIC savings Employee sacrifices a slightly higher amount so that they can get the same take home pay. The higher sacrifice means they get an increased pension contribution. WHICH OPTION IS BEST? There is no right or wrong answer. It s really up to the employer to choose which option they want to go for and this will depend on what their objective is, i.e. are they looking to reduce their costs or give employees additional benefits? 4
THE BENEFITS Employers will pay less NICs The employees will be receiving a lower gross salary, this means the amount paid in NICs by the employer will also reduce. A quick way to estimate the NIC saving is to add up the total of employee contributions and apply the employer NIC payment rate of 13.8%. For example: Average employee salary 20,000 Average employee contribution rate x 5% Annual employee contribution = 1,000 Active members x 50 Total = 50,000 Employer NIC rate x 13.8% Annual employer NIC saving = 6,900 Initially, paying by salary exchange rather than making payments directly may be off-putting to employees, as they will be receiving a lower gross salary. However, the individual will benefit from exchanging part of their salary towards providing for their retirement and at the same time, benefit from reduced NICs. This saving can be used to further enhance their pension contribution or alternatively increase their take home pay. Of course if the employer reinvests some of their NIC saving, the employees will also benefit from this. Adding value to the benefits package Introducing salary exchange can improve the employee s perception of their benefits package, particularly if the employer agrees to reinvest their NIC savings to further increase the pension contributions. This may encourage employees to join the scheme. A valuable benefits package can also help the employer to attract and retain quality staff, potentially giving employers an edge over their competitors. THINGS TO CONSIDER Salary exchange may not be suitable for everyone and it s important that the employer and employees are fully aware that it is a legally binding contract they are entering into. There are some other things that employers and employees should think about regarding the impact reduction in salary will have. Employees Other benefits which are linked to their salary, for example, benefits on death, redundancy payments and over-time rates may be impacted. Statutory benefits linked to the lower salary may also be impacted. These include: State pension Statutory maternity, paternity and sick pay. Working or child tax credit. More information can be found at www.gov.uk/salary-sacrifice-and-the-effects-on-paye Mortgage lenders usually base the amount which can be borrowed on the salary after the exchange; this will reduce the amount that the employee can borrow. Earnings must not fall below the National Minimum wage as a result of salary exchange. Rules for an Occupational Pension Scheme (OPS) state that if an employee dies while in pensionable service or if they decide to leave the scheme with less than two year s pensionable service, their contributions would be returned. This would not be the case with salary exchange, as the contributions would be considered employer contributions and therefore, contributions would not be returned. 5
Employers What they plan to do with the NIC saving they don t have to reinvest it but it may be difficult to promote salary exchange to employees if they are not going to benefit from this saving. Retaining a notional salary (this is the salary before the exchange) or reference salary for employees. This would mean that their pre-exchange salary could be used for things like mortgage references, over-time rates and pay increases. HMRC provide more information on this at: http://www.hmrc.gov.uk/manuals/eimanual/ EIM42771.htm The potential costs should an employee be absent from work for a long period of time, for example long-term sick. The new contract of employment moves the responsibility for making the pension payments from the employee to the employer so the employer would have to continue making the payments for the remaining exchange period if the employee is not receiving occupational sick pay. This would also apply to maternity leave. If the employer is considering a Smart Pension scheme we strongly recommend that they seek legal advice before any change is made. COSTS The costs associated with salary exchange are mainly related to the extra administration and employer s communications. There are 3 ways the costs could be covered. The employer could: bear the full cost of the set up use some of their NIC saving to cover part of the costs use all of their NIC saving to cover the costs. COMMUNICATION The success of a salary exchange scheme will be measured by how many employees sign up. There would be nothing more frustrating than an employer taking the time to set up a scheme and bearing the costs of this if take up is low. Clear communication is essential if a salary exchange arrangement is to be successful. To help we ve produced literature for employers and employees on how salary exchange works, how it can impact them and how it can benefit them. Employer Our employer guide details all four options and how they work as well as covering topics such as how to set the scheme up, the costs of setting it up and the benefits. Employee Our salary exchange flyer with the member joining guide details the benefits of contributing to the scheme, including case study examples. To accompany this we have also produced two employee quick guides highlighting the key benefits and potential disadvantages of salary exchange. One covers employer NIC reinvestment and the other no employer NIC reinvestment. CAN SALARY EXCHANGE BE ALTERED? For workplace pensions, HMRC have confirmed that salary exchange can be altered on request, with no requirement for a minimum period or for a lifestyle change to have taken place. SALARY EXCHANGE CALCULATOR We ve developed a salary exchange calculator which you can request from your Scottish Widows Account Manager. This calculator demonstrates how salary exchange works. It provides: bulk calculations individual calculations ability to save outputs links to our salary exchange website and literature information on how salary exchange works sample letters. 6
PAYROLL Implementing a salary exchange arrangement will have an administrative impact on the employer. The employer will need to think about how their systems and processes will be affected. If new procedures are necessary, how will this be communicated to the employees? We ve provided an example of what a payslip could look like on page 8. Basically, the employer should ensure the exchange amount doesn t appear under the deductions section. The entry can be described in any way, so long as it is clear enough for the employee to recognise it is the exchanged amount. NEXT STEPS... If you would like to find out more about salary exchange or discuss developing a communication strategy with any of your clients, we can help. For more information please get in touch with your Scottish Widows Account Manager or access our website at www.scottishwidows.co.uk/salaryexchange WHERE CAN I FIND OUT MORE? HMRC has extensive guidance on its website about salary exchange. You can find this information at: www.gov.uk/salary-sacrifice-and-the-effects-on-paye Some payroll software can only hold one salary for each employee. As long as the amended terms and conditions of employment have been clearly communicated to the employee, the salary exchange will be valid. 7
SAMPLE PAYSLIP Company name Employee name Joe Bloggs Pay Period 12 NI number Tax code AA 12 34 56 C 512L Employee payroll number 00000001 Employer tax office reference Contact telephone number XXX / X 01XXX XXX XXX Payments Amount Basic Pay Salary exchange - Overtime Bonus Total Deductions Amount Tax National Insurance Net Pay Amount Bank account details: XXXXXXXXXXXXXXXXXXXXXXXXX 8
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