Punter Southall Group
The DC Survival Guide • Briefing Note 6
March 2008
Taxing issues
This is the sixth of our briefing notes covering all
aspects of Defined Contribution pension schemes.
It seems that whenever pensions are involved, tax
and its close cousin National Insurance (NI) are never
too far away, and this issue of the DC Survival Guide
looks at how it works in practice.
Member contributions – net or gross?
Income tax relief is usually available on pension contributions
at the person’s marginal rate, provided contributions do not
exceed 100% of taxable earnings. The method of delivery
of the relief varies between different types of DC schemes.
In an occupational scheme, ordinary member contributions are
normally deducted via payroll. The contribution is taken from
gross pay and tax relief at the full marginal rate is granted
automatically. NI is still payable on the full gross pay. Where
Additional Voluntary Contributions (AVCs) are paid regularly,
these are treated in the same way as ordinary member
contributions. It is still permissible for schemes to accept AVCs
via other methods, for example one-off payments made by
cheque, although some may refuse to do so for administrative
reasons. If a member wishes to obtain tax relief on a one-off
AVC contribution that has not gone through payroll, this must
be claimed by completing a tax return.
The arrangements are different for Group Personal Pensions
and Stakeholder Schemes. Contributions are deducted from
net pay, after tax and NI have been deducted. Tax relief at
the basic rate is then credited automatically into the pension
scheme. If the member is a higher rate tax payer, he or she
will declare the amount of contributions paid and tax relief
already credited on a tax return, and additional relief up
to the higher rate is then refunded (or an adjustment made
to the tax code). Of course the member can then choose
whether to make an additional pension contribution with
any tax refund received or use the money for other purposes.
If you are changing from an occupational (trust based) DC
scheme to a contract based scheme (GPP or Stakeholder),
this difference in approach needs to be carefully
communicated to members.
Changes to the basic rate of tax
Changes to the basic rate of tax, such as the reduction from
22% to 20% at 6 April 2008, are therefore a headache for
contract based schemes. If the contribution rate is expressed
in terms of the percentage of salary after the addition of basic
rate tax relief, a cut in the basic rate means that members
have to pay more out of net pay to achieve the same end
result in their pension pot. Conversely, if contributions are
expressed as a fixed monetary amount taken from net pay,
the resulting amount credited to the pension pot will fall.
Salary sacrifice
Many employers have at least looked at, if not implemented,
salary sacrifice for member contributions. There can be a
very tangible benefit to the employees, particularly if some
or all of the employer’s NI saving is shared with employees.
How it works
The employee agrees to waive part of his or her salary, say
5%. The employer makes a corresponding contribution to
the pension scheme. The employee has never received the
salary, so pays no tax in respect of the contribution –
exactly the same as if it was a normal contribution. Under
current legislation, the employee does not pay NI on a
pension contribution paid by the employer on his behalf
so the employee sees an NI saving in his take-home pay.
Similarly, the employer does not have to pay NI on pension
contributions, so it too saves on NI. There is no obligation on
the employer to do anything in particular with this saving,
but some employers do choose to pay all or part of it into the
member’s pension pot – so the employee receives the benefit.
Some employees could receive a further indirect benefit, if
waiving part of their salary brings them to a level where they
become eligible for State benefits such as Working Tax Credits
When doesn’t it work?
Employees earning the minimum wage, or where earnings
after salary sacrifice would be below the minimum wage,
cannot make a salary sacrifice and must be excluded from
the arrangements.
Reducing salary voluntarily could affect an employee’s
entitlements to a range of contribution-related and
earnings-related State benefits, especially if it takes them
below the threshold for paying NI. Some employees will
therefore have a legitimate reason not to participate in
salary sacrifice arrangements.
Most employers retain a “notional” salary for death benefits,
based on the pre sacrifice amount. Employees will want to
make sure that the employer certifies the notional gross
salary on any mortgage or loan applications.
The salary sacrifice arrangement has to be properly
documented in order to be valid for tax and NI purposes,
so it is important to get professional advice on this.
The DC Survival Guide • Briefing Note 6
Finally, as there must be a variation in the contract of
employment, you need to get each current employee’s
consent to salary sacrifice, and usually this involves clear
communication of how it works and what the benefits are. As
it can all seem “too good to be true”, it is worth using pension
specialists for any written communications or presentations
to staff – otherwise it may be difficult to obtain consent.
It is also worth noting that salary sacrifice creates issues for
early leavers who would normally be entitled to a refund of
employee contributions. Since no employee contributions
are paid, a refund is not possible. Having immediate vesting,
or only offering salary sacrifice to employees who have
completed the vesting period, are ways round this.
Will it all be undone by future legislation?
Maybe! At present we think this seems unlikely, as HMRC have
said they have no intention to intervene in salary sacrifice
arrangements. HMRC’s Tax Avoidance Disclosure regime applies
separately to NI avoidance as well as to tax avoidance, but
HMRC have said that salary sacrifice arrangements as they
currently exist are very unlikely to need disclosure.
However, inevitably, as more and more employers take this
route, the Government’s NI income will fall, and some kind
of corrective action (direct or indirect) could be required.
What is the difference between AVCs and
ordinary member contributions?
In the DC world the answer is ”not much any more”! Before
A-Day, most people’s AVCs had to be converted to pension,
but now 25% of the AVC fund can be taken as tax free cash,
in exactly the same way as the main fund of employer and
employee contributions.
From a tax relief perspective, members may find it strange
that their own contributions can be paid via salary sacrifice
but AVCs cannot. It may be worth introducing variable
ordinary member contribution rates, chosen by the member,
as a way of taking away the rather confusing distinction, as
there is no real need to continue recording AVCs separately.
March 2008
members the option to contract out. Whether to contractout using an APP is an individual member decision, which
in practice is a very difficult one to make.
Partly because of this difficulty but also in a desire to
achieve some simplification in at least one area of pensions,
the Government announced in May 2006 its intention to
abolish contracting-out on a Money Purchase basis. The
precise date of abolition is not yet known, but the intention
was that it should happen in 2012 (now also intended to be
date of introduction of Personal Accounts). Abolition will
affect members of COMPS and APPs.
• It seems very likely that cessation of contracting-out will
be an automatic process, so schemes will not need to
submit any paperwork.
• COMPS in particular will require careful review, to reflect
that employer and employee rebates on NI will no longer
be available and scheme funds will build up more slowly
as a result.
• There will of course be a need to communicate with
members of COMPS over the reduction that they will
see in their net pay, as a result of moving to full rate NI
deductions.
• Members of APPs already pay full rate NI, but the NI
rebate is credited direct into their APP.
• Members of both types of schemes will need to be told
that they will start building up an entitlement to S2P
from the date of abolition.
Consultation continues over the transitional arrangements –
such as whether COMPS will always need to keep separate
records of Protected Rights funds (made up of contractedout rebates plus investment return). Another proposal is that
there may be an earlier cessation of new APPs, to prevent
new policies being set up for only one year of rebates.
We will look at the potential impact of Personal Accounts in
a later issue, but it is to be hoped that the dates for abolition
of Money Purchase contracting out and the introduction of
Personal Accounts do broadly coincide, so changes can be made
to DC schemes in a coherent, rather than piecemeal, way.
Contracting out
There are currently two ways of contracting-out of the
State Second Pension (S2P) on a defined contribution basis.
An occupational scheme that is contracted-out is known
as a COMPS (Contracted Out Money Purchase Scheme).
The alternative is to use a particular type of individual
personal pension to contract-out, known as an Appropriate
Personal Pension (APP). Sometimes an optional APP runs
alongside an occupational contracted-in DC scheme, to give
Where can I get further information?
For further information please speak to
Alison Bostock on 020 7839 8600 or email
[email protected]. Alternatively, please
speak to your usual Punter Southall Group contact.
This briefing note is provided by Punter Southall Limited, which is part of the
Punter Southall Group, for general information only and should not be relied
upon as advice on your specific circumstances.
For more information about the Group, visit our website at www.puntersouthallgroup.com
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