Higher earners face £50k pension hole if Reeves caps salary sacrifice in Budget

Higher earners could be left with pension pots £50,000 or more smaller under plans believed to be under consideration by Chancellor Rachel Reeves in her upcoming Budget, according to analysis.

Reform of salary sacrifice pension schemes is being heavily tipped as one way Reeves will seek to boost the public finances in the Budget on 26 November.

Salary sacrifice for pensions – also known as salary exchange – is where an employee gives up a portion of their salary in return for their employer paying an equivalent amount into their pension. There is a National Insurance Contribution (NIC) saving to both employees and employers from this arrangement, which costs the Treasury around £4 billion a year.

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Around a third of private sector employees make use of salary sacrifice arrangements, and almost 10% of public sector workers do so too, according to government figures.

Initially an all-out ban on using salary sacrifice was thought to be under consideration by the chancellor. However recent rumours have suggested a preferred option on the table is a £2,000 cap on the amount of earnings that can be exchanged for pension contributions that benefit from a National Insurance exemption.

Charlene Young, senior pensions and savings expert at AJ Bell, said: “Introducing the cap could reportedly raise up to £2 billion a year, but it also runs the risk of savers having less in their pension pots when they reach retirement.”

AJ Bell’s analysis showed that someone aged 35 earning £50,000 a year could face a hole in their pension of £22,060 by age 65 under plans to cap salary sacrifice. This assumes they already have a pension fund of £30,000 and save an overall contribution of 5% personally, with another 3% coming from their employer.

The black hole rises to over £37,000 or even nearly £50,000 if they are already a higher earner on £75,000 or £100,000 respectively, based on the same assumptions.

“Although clamping down on salary sacrifice isn’t an explicit tax rise, many employees will see less in their pay packets and ultimately their pension pots too,” said Young.

“A £2,000 cap means someone earning £40,000 now and making the 5% employee minimum contribution across all their earnings would be caught. And those diligently saving more than the current minimum would see more of their pension contributions subject to NI deductions, including some lower earners,” she added.

Employers faced with the added admin of policing a cap versus the current system might even decide to close their salary sacrifice schemes completely as a result of such a policy.

“In those circumstances, the dent in the pension pots of employees could be even higher than predicted – not an ideal message for a government supposedly committed to improving pensions adequacy and boosting the long-term saving prospects of the nation,” Young said.

How likely are changes to salary sacrifice pensions?

Earlier this year, research into salary sacrifice commissioned by HMRC led to some speculation the government may seek to make savings by abolishing or reforming salary sacrifice for pension contributions, with an announcement potentially in the Budget.

But the removal or closure of these schemes to save the Treasury money would “cause confusion, reduce benefits to employees, and disincentivise pension savings”, the Society of Pension Professionals (SPP) has said in a letter to all 650 MPs – including chancellor Rachel Reeves.

Changing salary sacrifice arrangements would lead to a reduction in take home pay for any employees currently making use of these arrangements – unless they reduced their pension contributions too, the Society of Pension Professionals has said.

Steve Hitchiner, chair of SPP’s tax group, said: “Changing salary sacrifice arrangements would lead to a reduction in take home pay for millions of employees who are saving into a workplace pension.”

“It would also represent another sizeable cost to employers, despite the chancellor’s public commitment against this, and would undermine the critical role that employers play in supporting and promoting good quality pension saving vehicles.”

How does salary sacrifice work?

Salary sacrifice for pensions works by an employee exchanging some of their salary in return for their employer paying the same amount into their pension.

While funded by the employee, these contributions are treated as employer pension contributions for income tax and National Insurance purposes. This means pension salary sacrifice normally leads to savings in both the employee and employer NICs.

This is because NICs are not due on employer pension contributions, whereas employee pension contributions are made after the deduction of National Insurance.

AJ Bell gave the example of Sally who earns £55,000 and wants to make higher personal contributions to her workplace pension of 10% a year. Her employer has offered her salary sacrifice as an option. The table shows the impact with and without salary sacrifice.

“As well as Sally’s own savings, her employer also saves employer NI on the £5,500 pay sacrificed, an extra £825 for the year,” Young pointed out.

However, many employers share their NIC savings with their employees, meaning more is added to their pension, and salary sacrifice also allows employees to pay higher pension contributions for the same net pay.

While salary sacrifice helps workers save up to 8% employee National Insurance (NI) on the cost of their pension contributions, the savings on offer are bigger for employers – as employer NI of 15% would’ve been payable on the amount of pay that is sacrificed.

The Society of Pension Professionals pointed out that while there is a £4 billion cost to the government in providing salary sacrifice arrangements – £1.2 billion for employees and £2.9 billion for employers – there is also “widespread recognition that this is a positive investment that incentivises pension saving”.

Martin Willis, partner at pension firm Barnett Waddingham, said: “Rumours are again circling about changes to, or the scrapping of, salary sacrifice. While this could help the government recover National Insurance revenue, in practice it would be highly disruptive, complex, and introduce additional cost pressures for employers.

“Previous suggestions of a cap on salary sacrifice may help protect middle earners, but in reality this could add complexity while still squeezing employer costs and contribution rates. Alternatively, removing salary sacrifice entirely would hit average earners the hardest, particularly those relying on it to boost their pension savings.

“Policymakers should think very carefully before pursuing reforms that make it harder for ordinary workers to save for retirement.”