New measures to make one-off payments to members from DB surplus easier

From April 2027, trustees of defined benefit (DB) schemes that meet specified funding criteria will be able to pay surplus funds directly to scheme members who are over the normal minimum pension age (currently 55, but increasing to 57 from April 2028), where permitted to do so under the scheme’s rules and subject to trustees’ discretion. Currently, this type of one-off lump sum payment is not permitted so it would be treated as an “unauthorised payment” under the pensions tax rules and incur a high tax charge if made. It is not, therefore, a payment which trustees would typically consider. 

HM Revenue & Customs (HMRC) subsequently confirmed in its Newsletter 175 that any payments made to members under the new rules would be an authorised payment and that they would be taxed as pension income at the individual’s marginal rate of tax.

We have yet to see the legislation implementing the change but our expectation is that the additional flexibility to make these payments will be helpful for trustees and employers, particularly if they are negotiating return of surplus to the employer. Changes to legislation in order to facilitate the return of surplus to employers are, separately, already in the process of being implemented via the Pension Schemes Bill. Under the draft legislation trustees would need to agree to any release of surplus back to employers: for some trustees this new flexibility could make it easier to justify agreeing to return surplus to the employer on the basis that some will also be returned to members. This one-off lump sum could be more attractive to trustees (and employers) than the option of augmenting members’ pension benefits (e.g., additional pension increases) as this increases the overall defined benefit liabilities in the pension plan.  

Salary sacrifice changes

The government has announced that, from April 2029, only the first GBP 2,000 of employee pension contributions through salary sacrifice will be exempt from employee and employer national insurance contributions (NICs).    

Employee contributions can still be made into pension arrangements above GBP 2,000 through sacrifice arrangements.  However, employee contributions above this amount will be subject to employer and employee NICs. Employer pension contributions will continue to be exempt from employer NICs.

It is important to note that the new threshold which is being introduced is a limit on NICs savings which can be made by employers and employees: it is not a limit on the amount of pension contributions which can be made by employees (or employers).  

The government has confirmed that all employee pension contributions will remain exempt from Income Tax, and that it is introducing the change from 2029 to “give individuals and employers time to adjust to these new arrangements.” 

References to salary sacrifice arrangements below refer to arrangements relating specifically to pension contributions

HMRC has published a guidance note to explain the changes. 

How does sacrificing salary for pension contributions currently work? 

UK pension salary sacrifice arrangements involve an employee agreeing a variation to their contract of employment to give up part of their salary in exchange for an equivalent amount to be made by their employer into their pension on their behalf. Contributions made in this way are sometimes referred to as “deemed member contributions”, as they are made instead of the “normal” employee contributions under the pension arrangement. 

Operating salary sacrifice on pension contributions results in savings for both the employee and the employer in the form of tax saving on employee and employer NICs respectively. This is because the employee’s earnings, on which both the employee and employer NICs are calculated, are reduced by the level of the salary sacrificed. So, for example, if an employee earns GBP 50,000 and there is no salary sacrifice in place, employer and employee NICs would be calculated based on the full GBP 50,000. If an employee agrees to sacrifice GBP 2,000 in return for pension, their earnings would be reduced to GBP 48,000 for these purposes. 

Currently, employees pay primary NICs at a rate of 8% on band earnings between 242 and GBP 967 per week (GBP 12,584 and GBP 50,284 per annum) and 2% thereafter. Employers pay secondary NICs at a rate of 15% on all earnings above GBP 175 per week (GBP 9,100 per annum).

Some employers share some or all of the saving which they have made with the employee by making an additional contribution into the employee’s pension arrangement. 

In addition to these tax advantages, salary sacrifice arrangements also offer high earners the additional benefit of not having to reclaim higher tax income tax relief on the amount which has been paid into their pension.  

What will this change mean for employers?

In preparation for the salary sacrifice changes, there will be various matters that employers will need to consider:

• Cost implications: Employers are likely to need to do some detailed modelling to understand the full impact of the changes.  Broadly, the extent of any additional costs for employers will depend on how an employer’s arrangement is structured prior to the 2029 changes, including whether or not the employer shares any of its own NICs saving with relevant employees. Employers will be incurring more cost to the extent that they currently “keep” any of the employer NICs savings that arise from salary sacrifice. In our experience, a number of employers do, however, currently choose to pass back all or part of the saving on employer NICs to their employees.
• Continue to operate sacrifice arrangements for pensions?  Employers will need to decide if they wish to continue with sacrifice arrangements after April 2029 (but with the new threshold in place) or whether they wish to terminate them.  Although there will still be tax advantages for employers in continuing with such arrangements, the extent of these savings will be reduced due to the operation of the threshold. The potential savings (albeit reduced) will need to be balanced against the increased complexity of operating such arrangements. 

A further factor which employers may take into account is the impact of this cap on the continued funding of salary sacrifice contributions during maternity leave. This is a highly complex issue which may require individual modelling to determine whether employers will no longer effectively receive funding in the form of NICs savings which, on average, covers the costs of contributions made during maternity leave.

• Maintain current pension contribution rates? Depending on how employers structure their pension contributions, at the relevant time, they may wish to alter employer contribution rates as a result of increased costs flowing from the loss of NICs savings. If employers are considering reducing employer contribution rates, they will need to ensure that they continue complying with pensions auto-enrolment requirements after the changes.
• Wider impact? Employers may need to consider whether additional changes are required to other aspects of their benefit packages as a result of any pension cost increases.  
• Communicate with employees about the changes: The impact of the changes on employees will need to be carefully communicated. The details of how employees are impacted will depend on how the arrangements are structured at the point of the change, including whether the employer is then sharing any savings with their employees. Employees contributing above the GBP 2000 threshold are likely to be worse off as a result of the changes, so high earners will be particularly impacted (as they will likely have larger pension contributions). Where employers are terminating salary sacrifice arrangements, they will also need to think about communicating with employees who are higher rate tax payers about any changes to the process for claiming income tax relief on their pension contributions. Certain changes may require formal 60-day pensions consultation (more detail below). 

Legal considerations

Reviewing contractual documentation and automatic enrolment considerations: 

• Employers will want to check existing salary sacrifice documentation to ensure that any changes to salary sacrifice arrangements are permitted, particularly where the changes will result in the reduction or removal of any current sharing arrangements.
• If employers are considering wider changes, such as reductions to current employer contribution rates, they will also want to check that this is permitted under the current contractual documentation and that they will continue to comply with their employer duties under the automatic enrolment legislation after the change. 

60-day pensions consultation?

• Employers will need to consider whether any changes which are being made to their current arrangements will trigger a legal requirement to consult with their employees. Whether or not a requirement to consult is triggered will depend on the changes being made in each particular case. Where reductions are being made to existing employer contribution rates, consultation is likely to be required in most cases. 

New withholding requirement for trustees as part of the new IHT regime from April 2027

The Chancellor also announced that, in the context of the forthcoming changes to the Inheritance Tax treatment of unused pension saving, personal representatives will be able to direct pension scheme administrators to withhold 50% of taxable benefits for up to 15 months and to pay Inheritance Tax due in certain circumstances. This change will take effect from 6 April 2027.

Under the current draft legislation, there is a facility for beneficiaries to request that trustees pay inheritance tax on their behalf, but the current legislation does not allow personal representatives to do this. The new requirement could give rise to issues for trustees and administrators, for example if trustees are not able to verify the identity of the personal representatives who are making any such request before the time limit for making any payment expires (trustees would typically rely on a grant of probate to verify, but this can take a considerable amount of time). You can read more about the changes to IHT regime in this alert.

PPF and FAS members to receive additional increases

The government also announced in the Budget that it intends to legislate to introduce CPI-linked increases in pre-1997 benefits, capped at 2.5% per year, for members of the Pension Protection Fund (PPF) and the Financial Assistance Scheme (FAS), where the original scheme provided this benefit. This change will take effect from January 2027.

And finally, what did not change?

Despite speculation in the weeks leading up to the Budget that the Chancellor could be considering restricting the amount of tax free cash that individuals could take from their pension, this did not transpire. 

The annual allowance and the tapered annual allowance, which, broadly, operate to restrict the amount of saving which individuals can make into their pension without incurring an income tax charge will not change from their current levels.

A copy of the underlying Budget policy paper can be found here.

Next steps

Please get in touch with your usual Baker McKenzie contact if you would like to discuss anything covered in this alert further.