I recently went through an interesting exercise at work and wanted to share the findings here. Essentially, my company don’t offer salary sacrifice pension contributions and I wanted to persuade them to consider it!

As you can probably tell, I’m bit of a personal finance nerd! I created a document showing the benefits of salary sacrifice to both employer and employees. I even added some Sankey Diagrams to demonstrate the difference it would make!

The information below shows what I submitted to my employer. Hopefully it will help explain the different pension contributions as well as giving you inspiration to request similar changes from your own employer!

Nothing in this post is meant to be advice. The best course of action for your individual situation will be just that – individual!

The information in the article is correct at the time of posting (to the best of my knowledge). I’ll try to keep it updated but I make no promises. Always do your own research!

Pension Tax Relief

As an incentive for people to save for retirement, the government offer a ‘top up’ whenever you contribute to your pension. This ‘top up’ is in the form of tax relief.

Tax relief is available on your pension contributions at the highest rate of income tax that you pay. In England, this could be 20% (basic rate), 40% (higher rate) or 45% (additional rate).

How Does It Work?

The way pension tax relief works depends on what kind of pension scheme you are in.

With a ‘relief at source’ scheme, your pension contribution is taken after tax. HMRC then pay the tax relief back on contributions.

With a ‘net pay’ or ‘salary sacrifice’ scheme, the pension contribution is deducted before tax is calculated on your pay. This means you receive tax relief there and then.

Relief at Source

Personal pensions, stakeholder pensions and some auto-enrolment workplace pensions tend to use relief at source arrangements.

Pension contributions come from income which has already been taxed. Your employer will only take 80% of your total pension contribution from your salary. HMRC then pay the additional 20% back later. If you pay tax at higher than 20%, you then claim the additional relief directly from HMRC accordingly.

So, if you earn £100 a week and pay 4% pension contributions, you will only actually have £3.20 deducted from your pay. The extra £0.80 will be paid into the pension scheme by way of tax relief at a later date. This tops up your £3.20 contribution to £4.00.

If you’re a higher or additional rate tax payer, you can either:

• Add the claim to your Self Assessment tax return
• Fill out a P810 Tax Review (call to request)
• Use your online Personal Tax Account to give the appropriate info

If you pay tax through PAYE, HMRC can give you any relief through your tax code. That way you will receive your ‘refund’ by paying less future tax.

The amount of relief given through your tax code will, however, only be an estimate unless you can say exactly how much you will pay into a relief at source pension scheme during the coming year. Over or under-payments can be resolved at the end of the year.

Net Pay (Salary Sacrifice)

Many traditional company pensions use net pay (or salary sacrifice) arrangements. They’re also used by some workplace pensions set up under the auto-enrolment programme. With this system, you don’t have to do anything to get your tax relief.

Your employer deducts pension contributions from your salary before tax. This means you get tax relief at your highest rate automatically.

So, if you earn £100 a week, and pay 4% in pension contributions, you will only pay tax on wages of £96. As you don’t pay tax on the £4 that you put in as your pension contribution, you are saving tax of £0.80 (£4 x 20%), meaning your £4 contribution is only really costing you £3.20.

This process will usually apply the right amount of tax relief automatically. This avoids the process of claiming the additional relief as in a relief at source scheme.

Which is Better?

For most people, a net pay/salary sacrifice arrangement will be more beneficial.

The power of this arrangement comes from the fact the contributions are taken before other deductions. This means not only do you not pay tax on this amount, but you also avoid National Insurance (NI) and potentially student loan payments on the difference in salary.

Where this really comes into it’s own is when you sacrifice more than the standard pension contribution amount. If your company allow, this means you can sacrifice a large proportion of your salary, instead receiving this payment into your pension. You then don’t pay NI, tax, student loan payments etc on the sacrificed amount.

While my understanding is that you can do ‘additional’ salary sacrifice on either type of pension scheme, this makes much more sense on a ‘net pay’ pension arrangement. The scheme will already be set up in this way (deducted before tax etc) so the employer is much more likely to offer the ‘additional’ option.

There are some potential downsides of salary sacrifice schemes to look out for:

• Low earners need to ensure they stay above ‘minimum wage’ levels of pay.
• Due to the effective reduction in your salary, the amount you are eligible to borrow for a mortgage may be reduced.
• Student loan payments will reduce. If you’re intending to pay this off, you may end up accruing additional interest.

Monevator recently posted about some of the downsides of salary sacrifice, particularly in interesting economic times such as now. This is well worth a read and you should be 100% comfortable with these factors if considering using salary sacrifice.

Worked Examples

Below are some worked examples of the impact this can have on the total benefits package of 2 ‘model employees’.

The numbers are based on my current pension scheme, which is relief at source with the employer matching up to 4% of contributions.

Employee 1

Employee 1 earns £60,000 and does not have an outstanding student loan. The scenarios considered here are:

• Relief at source option with employer contributing 4% (£2,400) and employee contributing 4% (£2,400).
• Salary sacrifice option for direct comparison. The employer contribution now becomes 8% (£4,800), with the employee’s salary reduced accordingly. This demonstrates the immediate difference this scheme would make to my employer.
• Salary sacrifice but with an additional ‘sacrifice’ of £4,500. This represents a total pension contribution of 15.5%.
• Salary sacrifice, this time with a more significant additional ‘sacrifice’ of £9,000. This represents a total pension contribution of 23%.

Employee 2

Employee 2 earns £30,000 and pays a Plan 1 student loan. The scenarios considered here are:

• Relief at source option with employer contributing 4% (£1,200) and employee contributing 4% (£1,200).
• Salary sacrifice option for direct comparison. The employer contribution now becomes 8% (£2,400), with the employee’s salary reduced accordingly. This demonstrates the immediate difference this scheme would make to my employer.
• Salary sacrifice option with an additional salary ‘sacrifice’ of £2,000. This represents a total pension contribution of 14.7%.

These examples represent 2 average employees within my company. Employee 1 is a more senior staff member while Employee 2 is a couple of years into their career, still paying off student debts.

I chose the additional salary sacrifice amounts at a level I thought was ‘realistic’ for the average employee. Obviously the more you’re willing to sacrifice, the more beneficial this scheme becomes!

The most important process in terms of getting this past my employer was the immediate comparison between the ‘current’ system and the salary sacrifice equivalent. See the examples below for a bit more detail on the numbers.

Example 1 – £60,000 Salary

Without Salary Sacrifice (Current System)

In this example, the employee has a gross salary of £60,000.

Without salary sacrifice, the total cost to the employer is £69,468, with the employee receiving total benefits of £45,660. This is the current situation at my company, with default pension contributions of 4% each from employer and employee.

With Salary Sacrifice to match 4% Contributions

Now, assume the change is made to a salary sacrifice system. The pension scheme receives the same overall contributions (in total, 8% of salary).

With salary sacrifice, the total cost to the employer is £69,137 (£331 less due to reduced NI), with the employee receiving total benefits of £46,848 (£1,188 more).

This example assumes the company keep the full £165 saving on NI. Many companies choose to add all (or a proportion) of this amount into the employee’s pension as well. This further increases the benefit to the employee!

With £4,500 Additional Salary Sacrifice

Now, assume the employee decides to ‘salary sacrifice’ £4,500 of salary on top of the pension contribution mentioned above. The employer will instead contribute this whole amount to their pension.

The total cost to the employer is now £68,516 (£952 less than the current system and £621 less than the initial salary sacrifice option), with the employee receiving total benefits of £48,738 (£3,078 more than the current system and £1,890 more than the initial salary sacrifice option).

This is due to not paying tax, NI and employers NI on the additional £4,500 of salary.

Many employers choose to give some or all of their NI saving to the employee as an additional pension contribution, acting as a further incentive to make use of this scheme.

With £9,000 Salary Sacrifice

Now, the employee decides to ‘salary sacrifice’ £9,000 of salary. The employer will instead contribute this whole amount to the pension.

The total cost to the employer is now £67,895 (£1,573 less than the current system and £1,242 less than the initial salary sacrifice option), with the employee receiving total benefits of £50,488 (£4,828 more than the current system and £3,640 more than the initial salary sacrifice option).

This is due to not paying tax, NI and employers NI on the additional £9,000 of salary. This level of salary sacrifice drops this employee below the £50k tax bracket so has a really big impact.

Many employers choose to give some or all of their NI saving to the employee as an additional pension contribution, acting as a further incentive to make use of this scheme.

Side by Side Direct Comparison

The most important comparison when persuading my employer to switch is a direct comparison between the current system and the salary sacrifice equivalent.

With the 2 graphs side by side, you can easily compare the schemes and see the benefits of the salary sacrifice option. You might have to make the image full screen to see the detail!

Example 2 – £30,000 Salary

Without Salary Sacrifice (Current System)

In this example, the employee has a gross salary of £30,000. This employee also pays student loan payments on Plan 1.

Without salary sacrifice, the total cost to the employer is £34,128, with the employee receiving total benefits of £24,524. This is the current situation at my company, with default pension contributions of 4% each from employer and employee.

With Salary Sacrifice to Match 4% Contributions

Now, the change is made to a salary sacrifice system. The pension scheme receives the same overall contributions (in total, 8% of salary).

With salary sacrifice, the total cost to the employer is £33,962 (£166 less due to reduced NI), with the employee receiving total benefits of £24,776 (£252 more).

This example assumes the company keep the full £166 saving on NI. Many companies choose to add all (or a proportion) of this amount into the employee’s pension as well.

With £2,000 Additional Salary Sacrifice

Now, the employee decides to ‘salary sacrifice’ £2,000 of salary on top of the pension contribution mentioned above. The employer will instead contribute this whole amount to their pension.

The total cost to the employer is now £33,686 (£442 less than the current system and £276 less than the initial salary sacrifice option), with the employee receiving total benefits of £25,596 (£1,072 more than the current system and £820 more than the initial salary sacrifice option).

This is due to not paying tax, NI, student loan and employers NI on the additional £2,000 of salary.

Many employers choose to give some or all of their NI saving to the employee as an additional pension contribution, acting as a further incentive to make use of this scheme.

Side by Side Direct Comparison

The most important comparison when persuading my employer to switch is a direct comparison between the current system and the salary sacrifice equivalent.

With the 2 graphs side by side, you can easily compare the schemes and see the benefits of the salary sacrifice option. You might have to make the image full screen to see the detail!

Conclusion

As you can see, I made quite a convincing argument to my employer that this scheme is beneficial to all parties! Looking at some of the numbers in the examples, it would be hard to stick with the current system.

The choice for my employer is as follows:

• Keep the current system, ignoring the additional benefits of salary sacrifice in order to avoid the (relatively small) costs involved in setting this up
• Set the scheme up, keeping hold of the ’employers NI’ saving  in order to offset the start-up costs. Once the scheme has paid for itself, these can then be handed over to the employee.
• Set the scheme up, handing over the full ’employers NI’ saving to the employee. This then becomes a significant additional benefit to offer new and existing employees, at very low cost to the employer.

My preference would be for the latter, but my expectation was the middle option! I had several positive conversations with the company accountant. he also passed this by the Directors.

Unfortunately, Coronavirus hit just as my suggestions gained approval. Our accountant has since been somewhat preoccupied with keeping the company afloat! Fingers crossed this will reappear when things eventually calm down!

The impact this would have on my FIRE path is clear. My savings rate could be increased significantly, while costing the employer less! If this scheme is implemented, I would put much more into my pension and less into my stocks and shares ISA, altering the plan set out here.

Resources

Having toyed with this idea for a while, the final piece of inspiration to go ahead was this great piece by Monevator. It really shows the stark impact a salary sacrifice scheme can have on your savings ability.

A tool called SankeyMatic was used to generate all of the above ‘Sankey’ diagrams. They’re popular for showing people’s budgets but can be handy for showing any kind of weighted flow data.

The Money Advice Service produce a lot of easy to digest guidance. Here’s their page on tax relief on pensions, which I used a lot!

The Government website was used to make sure the latest information was adopted for tax, NI etc.

This calculator by Legal & General give a really easy comparison for salary sacrifice pension contributions.

As usual, all of my numbers on income were ran through The Salary Calculator. This is a great, simple to use tool for working out your take-home and assessing various different options.

Another good article on pension tax relief.