The Chancellor announced in her Budget speech the news many of us had been reading about for days – and the Office for Budget Responsibility had confirmed via a “technical error” hours earlier – that the use of salary sacrifice to boost workers’ pensions would be restricted to a maximum of £2,000 a year.
Though the news was not unexpected, it is nevertheless an unwelcome restriction, which will reduce pension saving and further complicate an already intricate and hard-to-navigate system.
The move makes sense for a Chancellor with money to raise who wants to target higher earners in as technical a way as possible, so people can’t readily see the damage this will do.
It’s not at all clear though, how effective it will actually prove to be, for reasons I set out below.
How salary sacrifice works
Salary sacrifice is when an employee agrees with their employer to give up a portion of their income, in exchange for an alternative benefit, such as a pension contribution.
If the money is paid as income, it is liable for income tax and national insurance (NI). By opting to have it paid into a pension by the employer, in effect it no longer exists as salary, so is no longer liable for that tax and NI.
If an employee chooses to pay the money into a pension after receiving it as pay, then they get to claim back the tax, but the NI remains lost to the government.
This means from an income tax point of view, whether you fund a pension through your employer or out of your net pay makes no difference, but funding through an employer saves the NI.
This saving is not insignificant. Employees pay NI at a rate of 8 per cent (on income up to £50,270, after which the rate drops to 2 per cent).
Employers pay at a rate of 15 per cent. So, if you make a sacrifice into your pension of £5,000, the total saving can be £400 plus £750.
Whether the employer chooses to share their saving with the employee is up for discussion between them.
What changes as a result of the Budget
The Budget announcement means that from 2029, this dodge to avoid the NI will be restricted to a maximum sacrifice into a pension of £2,000 a year.
This means lower earners are unlikely to be affected – someone paying a pension contribution of 5 per cent on an income under £40,000 would not hit that £2,000 limit.
But it is particularly bad news for those fortunate individuals earning around the £100,000 level, above which they suffer an effective tax rate of 60 per cent due to the clawback of their personal allowance. At this level of income, salary sacrifice is quite commonly used and for quite significant sums of money.
The change won’t come in until 2029, for which we must be grateful. Businesses and individuals will need time to adjust. Employment contracts will need to be amended, pension contribution rates adjusted, payroll systems updated. All of this costs time, money, inconvenience; mistakes will inevitably be made.
Will it work? Maybe not
According to the forecasts, 76 per cent of the additional employment cost caused by the salary sacrifice restriction will be passed on by employers to employees, partly in the form of lower pension contributions and partly through lower wage settlements.
Interestingly, the official forecasts show a substantial saving to the Exchequer of £4.7 billion in 2029 following the introduction of the new rules, dropping to £2.6 billion in 2030-31.
This implies significant adaptation responses to the new rules, as employers and employees look for ways to compensate for the restriction.
In some cases, individual employees will still negotiate bespoke terms with new employers. This will be hard for HMRC to police. In some workplaces, employers may simply shift all their pension funding to a non-contributory basis, and then over time adjust salaries to reflect this.
The Government acknowledges that some workplaces may just rewrite employment terms to work around the rules, but they are relying on employment law and the fact the workaround would have to apply to the whole workforce to limit this solution.
Given that many businesses don’t currently offer salary sacrifice, it is possible we’ll even see more firms start to use it to save money on pension funding now that it is being officially endorsed by the Treasury.
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The other thing to bear in mind is that in today’s volatile political and economic environment, 2029 is still a long way off. A lot could happen between now and then.
All in all, this is a policy which makes sense only for a desperate Chancellor, but I’m by no means convinced it will raise anything like the money she hopes for. The one thing it will definitely do is make life more complicated for anyone trying to save for retirement.
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