Justin Corliss, technical and pensions expert, Royal London, looks at how salary sacrifice works, the suggested changes to it and the potentially long-term implications of reform on pensions savings.
Salary sacrifice is under HMRC’s spotlight as the Government looks to balance the public finances. In May this year, HMRC published research[1] exploring how employers use salary sacrifice for pension contributions and their views on potential changes to National Insurance (NI) benefits.
Salary sacrifice, or salary exchange, is a contractual arrangement where employees agree to give up part of their salary in exchange for non-cash benefits, like pension contributions. This reduces taxable income, offering tax and NI savings for both employers and employees.
Salary sacrifice rules have changed before and may change again. In 2016, the Government implemented amendments to salary sacrifice schemes, reducing the range of benefits eligible for associated tax advantages. For instance, it was no longer permissible to benefit from salary sacrifice on:
– Company cars (except ultra-low emission vehicles)
– School fees
– Health screening and medical check-ups
These changes aimed to reduce tax revenue losses but also sparked discussions about the future of salary sacrifice schemes, particularly for pensions.
Fast forward to 2025 and research, completed in 2023, highlighting employers’ views and analysis of how they use salary exchange in their workplace pension schemes is being scrutinised.
Given the small sample, 51 employers, with 41 who used salary sacrifice in workplace pension schemes, the findings needed to be interpreted carefully. The three hypothetical changes were:
• Remove the employee and employer NI saving on pension contributions made via salary sacrifice
• Remove the employee and employer NI saving on pension contributions made via salary sacrifice as well as employee tax relief
• Remove the employee and employer NI saving on pension contributions made via salary sacrifice in excess of £2,000
Broadly speaking, employers surveyed were not supportive of any of these options, although the third option was deemed slightly more palatable than the other two.
Who benefits most from salary sacrifice?
Many workers can benefit from the use of salary sacrifice on pension contributions, but different groups benefit in different ways, and this might not be obvious at face value.
When simply looking at overall cost savings or increase to pension contributions, the bulk of the saving in salary sacrifice is a NI saving. A basic rate taxpayer sacrificing a portion of salary in favour of a pension contribution could benefit from an 8% individual NI and a 15% employer NI saving. Both may be redirected into the employee’s pension. The employee would have received basic rate tax relief on their contribution anyway, so the income tax benefit, while valuable, would be similar without using salary exchange.
Higher and additional rate taxpayers still potentially benefit from the employer 15% employer NI saving, but as they only pay 2% NI at the top end of their salary, the individual NI saving is not as significant.
However, those higher and additional rate taxpayers making a pension contribution via salary sacrifice are effectively getting full marginal rate tax relief at source. Using the relief at source method of tax relief without salary sacrifice would get basic rate tax relief at source, with the remainder claimed from HMRC, often via self-assessment tax return. Potential issues with this include individuals neglecting to claim this additional tax relief, and those that do claim it, will likely see this returned to them via personal allowance adjustment. Therefore, the additional tax relief isn’t automatically paid to the pension, and the level of pension savings at the point of taking benefits may not be as great as a result.
Potential consequences
One of the central arguments against removing salary sacrifice on pensions is the potential adverse impact on pension savings. The UK is already grappling with a widely reported pension saving shortfall, and any move that might reduce pension contributions could exacerbate this issue.
Removing salary sacrifice might appear to be a cost-saving measure for the Government in the short term however, those savings have to be weighed up against some of the adverse consequences – such as possible cost impacts on employers and the longer term impact on pensions savings overall.
Here’s why:
Reduced pension contributions: Without the tax and NI incentives provided by salary sacrifice, both employers and employees might be less inclined to contribute to pension schemes. This could lead to a reduction in overall pension savings, further deepening the pension shortfall.
Lower pension pots will lead to lower retirement incomes, leading to reduced income tax (and potentially inheritance tax) receipts for the Government in the future
Increased reliance on state support: If individuals save less for their retirement, they may become more reliant on state support in their later years. This reliance could offset any immediate savings the Government realises from abolishing salary sacrifice on pensions.
Economic implications: Reduced pension savings could have broader economic implications. Pensions represent a significant pool of long-term investment capital, and any reduction in pension savings could potentially impact the wider economy.
The way forward
If HMRC decides to formally review salary sacrifice for pensions, it is crucial for policymakers to weigh the long-term implications of any changes. Stakeholders, including employers, employees, and pension providers, should be part of the conversation to ensure any changes support financial stability for an aging population.
Given the existing awareness of the pension savings gap, it would be essential to consider alternative approaches that could achieve the Treasury’s objectives without undermining pension savings.
HMRC’s renewed focus on salary sacrifice for pensions in 2025 highlights the ongoing evolution of workplace pensions and their regulation. While safeguarding public finances is critical, ensuring the sustainability of pension savings and addressing the pension shortfall must remain a priority too, especially in light of the aging population.
Engaging in a comprehensive and inclusive dialogue will be key to finding solutions that balance fiscal responsibility with the financial well-being of the workforce.
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