In recent years, the implementation of salary exchange, or salary sacrifice to give it its traditional name, has become increasing popular.
This is particularly notable in company pension arrangements. Instead of a direct employee contribution, a percentage of salary is exchanged for an employer contribution. Since employer contributions have no National Insurance liability, there is a significant saving for both employer and employee.
There are some side-effects to salary reduction, such as slower build-up of state second pension benefits, but in most circumstances the case for it is compelling.
If both employer and employee National Insurance savings are invested in the pension, the effective rate of tax relief for most basic-rate taxpayers increases from 20 per cent to 40 per cent. Even if the employer decides to retain some of the National Insurance saving, thus reducing the pension boost, it is still very worthwhile.
However, the advent of auto-enrolment from next year introduces complications. Salary exchange is certainly possible in conjunction with automatic enrolment.
Instead of the employee contributing 5 per cent including tax relief and the employer contributing 3 per cent, salary exchange can move the full 8 per cent to the employer. Indeed, that 8 per cent can be based on the reduced salary although I believe best practice would be to base it on pre-exchange earnings.
The complications arise in the mechanics of the exchange. The Pensions Regulator has made it clear that salary exchange can only be an option for existing staff, not a condition of joining the pension scheme. Employees must also be able to be automatically enrolled without salary exchange.
There is also a timing issue. The basis for salary exchange is that the reduced salary and corresponding pension contribution increase are agreed and documented before it takes place. However, the basis for auto-enrolment is the opposite of that – the individual is placed in the pension scheme and then given the right to opt out.
There are two ways round this issue. The first is for the employer to invoke the three-month waiting period allowed under automatic enrolment and arrange for the salary exchange to be agreed and documented during that period. With the exchange in place, the employee can then be automatically enrolled but would need to be warned that it would not be in their interests to opt out because the exchange cannot be cancelled.
A better way to manage this might be for the employees to opt into the pension as part of their agreement to salary exchange and they then do not need to be automatically enrolled, avoiding the timing contradiction.
The second possible method would be for the employer to go through the automatic enrolment process and then offer staff salary exchange. This would mean that initially payments into the pension would be on a full-salary basis with employee contributions but once the exchange was in place, all contributions would revert to the employer.
It will largely be down to individual employer preference as to which of these methods they choose or they may find a different way to effect the exchange.
Salary exchange is available under all types of DC pension, including Nest, but is most likely to be used with private sector providers who can help with documentation and calculation of the potential benefits. It may not be for every company, advisers should make employer clients aware of the option and of the potential benefits.
In these difficult times, anything with the potential to reduce employer costs and increase pensions contributions is likely to be welcomed.
Ian Naismith is head of pensions market development at Scottish Widows