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Salary sacrifice: the downsides in a crisis

Salary sacrifice can come back to burn you

Many Monevator readers will be reaping generous tax breaks on their pension contributions made available through salary sacrifice schemes.

But what’s less widely understood is that salary sacrifice can work against you if it lowers your salary below critical thresholds, or if your employer hasn’t been transparent about what your salary officially is.

Badly administered schemes operate in a grey area that leaves employees in the dark about potential downsides – such as the risk of reduced redundancy pay, sick pay, and other benefits – whether by accident or unscrupulous design. (Delete as applicable, although we can do without either in the midst of a worldwide recession).

What is salary sacrifice?

Salary sacrifice schemes are a contractual agreement between you and your employer to give up part of your salary in exchange for a non-cash benefit such as pension contributions, childcare support, bicycles, and ultra-low emission cars.

The upside is you do not pay tax or National Insurance Contributions (NICs) on your foregone salary.

Your employer doesn’t pay National Insurance on your sacrificed salary either. They can pass on their savings on to you, or they can sneakily trouser it for extra profit.

HMRC doesn’t seem to mind a bit so long as certain boundaries are observed.

What is the downside of salary sacrifice?

The downside of salary sacrifice is that it lowers your salary – and you’ve signed a contract saying that you agree to it!

Reducing your salary can reduce your entitlement to a slew of benefits that are related to your earnings level, including:

  • Redundancy pay
  • Notice pay
  • Pay rises
  • Overtime and bonuses
  • Holiday pay
  • Sick pay
  • Employer pension contribution levels
  • Life cover
  • Maternity / paternity pay
  • State Pension
  • Unemployment benefits
  • Incapacity benefit
  • Mortgage borrowing levels
  • Credit card borrowing levels

All of the above depend on your earnings level to some degree – or to your earnings clearing certain thresholds.

Your employer is under no obligation to measure those benefits against your pre-sacrifice salary (unless they’ve contractually agreed that with you).

In some cases it’s entirely out of their hands anyway. You shouldn’t be on a salary sacrifice scheme if it drops you below the National Minimum Wage (unless you’re exempt). It may also not work out for you if you’re subject to the tapered annual allowance. Hint: HMRC are alive to this caper and sacrificed salary is just added back to calculate your threshold income. It’s like shooting at the Borg.

Salary sacrifice: how it could cost you

Everything is okay if your employer clearly explained the issues to you before you signed your new contract sacrificing salary.

(Yes… of course they did.)

Alternatively, everything is groovy if your employer is completely trustworthy and not prone to doing over its own employees when cashflow is tight.

(Is it just me, or is it suddenly a bit hot in here?)

Things are still on a relatively even keel if your employer explained that you would retain a notional salary or shadow salary. In this case your pre-sacrifice salary counts when your employer calculates your right to contractual benefits that it controls, namely:

  • Redundancy pay
  • Notice pay and holiday pay
  • Pay rises
  • Overtime and bonuses
  • Contractual sick pay
  • Employer pension contribution levels
  • Life cover
  • Contractual maternity / paternity pay

If you don’t have a notional salary agreement then employers are perfectly within their rights to use your lower post-sacrifice pay to calculate these amounts – although they should have mentioned it before signing you up to salary sacrifice. I say they’re within their rights – obviously you work for ScuzzBucket plc if your employer does this kind of thing… can I interest you in a prospectus?

State benefits are calculated using your post-sacrifice salary and that’s the end of it. These include:

  • Statutory sick pay
  • Statutory maternity / paternity pay / adoption pay
  • State Pension entitlements
  • Incapacity benefit
  • Parental bereavement pay
  • Jobseeker’s Allowance and Employment and Support Allowance

You can ensure you don’t come a-cropper with some of these benefits (such as State Pension) by ensuring your salary doesn’t drop below the lowest threshold for National Insurance Contributions, or that you’ve built up a sufficient record of payments already or through credits.

A particularly generous employer can make a non-statutory ‘top-up’ payment to employees, if they’d like to make good any shortfall in statutory pay entitlement.

(Good luck with that!)

Salary sacrifice: can I change my agreement?

You can change your salary sacrifice agreement, but your freedom of manoeuvre is limited.

Your contract should specify your cash earnings and your non-cash benefits. Non-cash benefits are benefits that your employer pays for.

Your contract needs to change whenever your salary sacrifice agreement changes, and if you switch between cash and non-cash benefits too frequently then you lose your tax advantages.

The Government has outlined certain ‘lifestyle changes’ which justify a swift opt-out of your salary sacrifice agreement.

Example events include:

  • Changes to circumstances directly arising as a result of coronavirus (Covid-19)
  • Marriage
  • Divorce
  • Partner becoming redundant or pregnant

It’s also worth noting that your employer can’t force you into a salary sacrifice scheme, just in case you were wondering.

Salary sacrifice: does it reduce my pension annual allowance?

Salary sacrifice should not have any negative impact on your annual allowance although, as always with tax, seek more qualified advice if you’re worried about this.

The problem goes something like this:

  • Your pre-sacrifice salary: £40,000
  • You salary sacrifice: £25,000
  • Your post-sacrifice salary: £15,000

Does that post-sacrifice salary limit your annual allowance to £15,000 (less than you’re contributing!) because your tax relief is limited to 100% of your relevant UK earnings per tax year?

(I’m excluding those who’ve triggered the money purchase annual allowance (MPAA) or the tapered annual allowance.)

Your £40,000 pension annual allowance for defined contribution pensions consists of:

  • Your personal contributions
  • Your employer’s contributions
  • Third-party contributions – anyone else who kindly chips in for you

If the combined total of those contributions goes over your annual allowance and your carry forward, then you’re in for a tax charge.

You get tax relief on your personal contributions up to 100% of your relevant UK earnings or your annual allowance, whichever is lower.

Your employer’s contributions are not subject to your relevant UK earnings limit, only your £40,000 annual allowance limit.

Old Mutual puts it succinctly:

Personal contributions can be limited by relevant UK earnings but employer contributions are not.

Meanwhile, salary sacrifice converts your salary into an employer pension contribution as explained by Pru Advisor:

An employee could also save income tax, and National Insurance Contributions (NIC), by using a salary sacrifice agreement.

This is where they have a contract with their employer to exchange some of their gross salary (before tax) for a non-cash benefit, such as an employer pension contribution.

So it’s okay if salary sacrifice reduces your salary below the level of your total pension contributions – because your sacrifice is classified as employer contributions, and those do not attract tax relief.

However, personal contributions above your post-sacrifice salary will not gain tax relief either.

All of this is apparently confirmed by the Government’s own pension annual allowance calculator which does not ask how much you earned during the tax year. It’s only interested if you exceeded the £40,000 limit or if you tripped the MPAA or tapered annual allowance.

Salary sacrifice in a crisis

I’ve been happily maxing out my salary sacrifice for years in order to hit financial independence. I didn’t know about the downsides, nor was I made aware of them when I signed up.

That makes me deeply uncomfortable about what will happen should I catch a bullet. Maybe it’ll be alright, maybe not.

I don’t like grey areas and – given we face a recession of biblical proportions – I’ve cut my salary sacrifice to the bone.

Take it steady,

The Accumulator

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Weekend reading logo

What caught my eye this week.

After compiling this list of the best money and investing reads for over a decade now, it’s rare I come across anything super new.

But I loved this fresh idea from Pete The Planner on how to borrow money from your own emergency fund.

Hold up – borrow your own money?

That’s right. Sort of.

Pete explains it’s down to one of those endearing tics of being human. Many people would rather borrow from a lender – and pay interest – because they prefer to see a repayment schedule in place, rather than raid their own emergency fund that they’d diligently saved for a rainy day.

Even when it starts to rain!

One reason is they don’t trust themselves. But research provides a possible solution, says Pete:

In a lab experiment, researchers found that when subjects were given the option of taking money from savings and entering into a “pay-back” agreement, they were more willing to use their savings rather than borrow money.

So simple. See Pete’s blog for a quick example with numbers.

As somebody who got a mortgage because I couldn’t bear to spend the money I’d socked away in ISAs for this very purpose (okay, and to lose the tax wrapping) I can relate.

Anyone else found any leaks in their mental accounting buckets?

Let us know in the comments below.

[continue reading…]

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Get out of debt to unleash your inner money maker

Our series on why you must get out of debt looked at how credit cards can double the price you pay, at the cost of foregone investments, and why mortgages are the only good debt.

But there’s another reason to get out of debt.

It’s hard to price, but it may be the most valuable benefit of all.

It’s the peace of mind and the freedom to make money that comes with being debt-free.

When you’ve no debts, you literally don’t owe anyone anything. Your money is yours to use as you will.

Sure, you may feel you owe:

  • Your parents for raising you
  • Your friends for the good times
  • A beer to anyone who helped you in the bad times
  • Whoever gave you that spare bed in my third debt article

But financially-speaking, you’re free.

Many people who get out of debt unfortunately use that freedom to go straight back into the mire. They fill the void left by paying off their debts with… more debt.

A better plan is to keep up the momentum to grow your net worth. Redirect your former debt repayments towards saving and investing. Use your new financial flexibility to increase your earnings.

You can start investing with a tiny budget – indeed it’s free with Freetrade.1

The important thing is to get your snowball rolling!

Make money for yourself, not some bank

I’ve heard many times from people how liberating getting out of debt is.

They discover what I relish every day – that my monthly income is going wherever I want it to go, not on paying for stuff bought and forgotten about years ago.

Debt-free, you can save up an emergency fund, invest to create a future income – or just treat yourself to a meal out or new pair of shoes, guilt-free.

And here’s the real bonus – when you’re financially secure, you’re also more likely to look for ways to make money.

Everyone knows the rich get richer. Having compound interest working for you instead of against you is a big reason why.

But I believe there’s also a mental pay-off for being debt-free.

Operating from a position of strength, you are more able to think of money as an opportunity and a tool, rather than as a burden. Your whole outlook on money and the language you use can change. And that’s the first step to getting richer.

My co-blogger The Accumulator had to get out from under his debts before he could begin amassing his passive hoard and planning for financial independence.

As someone who has never borrowed money and so started investing with a clean state, I find his journey inspiring.

But I’d choose my debt-free journey over it, any day.

What about my pal Bob / Aunt Bertha / Donald Trump?

Sure, we all know a few people who (seem to) handle their debts and still grow their income faster than their repayments.

I’m not saying debt is always a fatal disease. Rather, that it’s a hugely debilitating one, which can easily catch up and snuff out its victims.

How much wealthier would those income-rich, asset-poor debt jugglers be if instead of shuffling credit card payments, they put their brainpower into growing their investments or creating a passive income stream?

Mortgages: The exception to the rule

If you’ve got any non-mortgage debt – even if you think it’s balanced by assets – pay it off as soon as you can. In every way it’s worth it.

Using debt to buy a property is the only exception. A mortgage is cheap debt, and it enables you to live in your own home today rather than saving half your life to buy one, chasing rising house prices along the way.

Nowadays even I have a big interest-only mortgage, and I truly hate debt.

But do you want to know a secret?

I love my home and overall I’m happier for finally owning my own place.

But I believe I was a better investor when I didn’t have a mortgage hanging over me.

The bottom line on debt

For most Monevator readers, I’m preaching to the choir.

But too many average people have too much debt – and it’s in tough times like recessions that they discover why they shouldn’t.

It can be hard to get out of debt. You’ll have to go without.

But all that really matters in life is health, friends, family, love, and useful work or another purpose you enjoy.

Well, and beauty and truth, as the poet said.

(And personally I’d add Mexican food.)

Last I looked, getting into debt to buy an iPad when you can’t afford it just to have one before your friends wasn’t on a single philosopher’s list.

  1. Open an account via that link and we can both get a free share worth between £3 and £200. You’re growing your net worth already! []
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The stock market is wilder than you think

This is one of the most revealing stock market charts I’ve ever seen. It shows just how rough the ride is when you invest in equities – in this case the FTSE All-Share index:

FTSE All-Share intra-year returns 1986-2020

[Click to enlarge the revelation]

Source: J.P. Morgan Guide to the Markets UK, 31 March 2020, p.92 (updated quarterly).1

Most investing books show only calendar-year returns when they explain how risky the stock market is. You can see these calendar year returns for the All-Share represented by the grey bars in the graph.

They go up and down like a lift operated by Mad Max. But even these violent mood swings are mild in comparison to the worst drawdowns2 contained within each year, picked out in red dots.

Those plunges really will make your stomach drop.

Market mania

What do 34 years of stock market swings and roundabouts tell us?

Firstly the -36% fall we saw through March 2020 is historically horrendous.

It’s beaten on the chart only by the -37% Black Monday Crash of 1987 and the -43% delivered during the Global Financial Crisis in 2008.

The main lesson though is that double-digit losses are a regular event, bedevilling investors in UK equities in more than 75% of the years covered.

On top of that:

  • A market correction (-10% to -19%) hit home more years than not (18 out of 34 years).
  • We entered bear market territory (-20% or worse) in nearly 25% of all years (eight out of 34 years).
  • Peak-to-trough losses were -30% or greater in five out of 34 years (that’s 15% of all years).

JP Morgan calculates the average intra-year drop is -15%. That shows 100% equities is no place for the nervous and attentive, even though the market ended up higher in a given year some 70% of the time.

Happily the years that saw double-digit declines still ended up in positive territory 44% of the time (15 out of 34 years), too.

Down but not out

Even truly terrible drawdowns can reverse quickly. 1987’s -37% decline transformed into a 4% gain by New Year’s Eve.

I can’t see that happening this year, and it didn’t happen during any of the other 30%+ down years either, but who knows?

Many other big losses rebounded into big gains:

  • 2009’s 23% down snapped back to 25% up.
  • 1999 dived 11% but rose 21%.
  • 1989 dropped 14% but climbed up 30%.

For new investors, this chart provides a more realistic picture of what you’re up against than you’ll get by just looking at the end-of-year tally. Equities are a much tougher place to be than I realised when I began investing, when seen through the lens of intra-year declines.

For example, the most brutal calendar year for UK equities was an off-the-charts -58% delivered in 1974.3

Yet even that pales against the sickening -73% inflicted by the UK bear market of May 1972 to December 1974.4

Forewarned is forearmed

Why am I heaping this misery on you when we’ve possibly only just binged on the first few episodes of an all-time equity horror show?

Partly because the graphic shows some good news. Things can – and often do – turn around more quickly than we think.

But also to be honest about the bad news. The stock market is a wilder place than many give it credit for.

Chalk it up as yet another reason to invest passively, to be diversified, and to only check your portfolio infrequently, lest you’re frightened out of it…

Take it steady,

The Accumulator

  1. Nominal returns, dividends not included. []
  2. Drawdowns are the decline in the price of an investment between its high and its low over a given period. []
  3. Barclays Equity Gilt Study, real return including dividends. []
  4. Sarasin Compendium Of Investment 2020, p.167. []
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