Hidden costs for employers as pension contributions increase

Out-Law Analysis | 31 Oct 2018 | 10:04 am | 2 min. read

ANALYSIS: Large employers could face a sizeable payroll increase from April if the increase in the minimum pension contribution for automatically enrolled workers is not managed properly.

The increase in the overall contribution rate, to 8%, should not come as a surprise to employers, who have already managed staggered rate increases over the past five years. However, the law only sets out a minimum contribution rate and a minimum employer contribution rate, but is silent on what the employee must pay. In the absence of any employee obligation under the contract, then the employer must pick up the difference.

This is particularly relevant to those employers with large workforces who have, in the past, adopted a pensions policy that has rewarded employees who contributed more while leaving the others to pay the statutory minimum.

Before April 2018, the minimum automatic enrolment (AE) contribution rate was 2%, with a minimum employer contribution rate of 1%. An employer may have offered enhanced pension contributions to employees who paid more than a minimum employee contribution of 1%. As a fairly typical example, employees who paid in at least 3% may have had those contributions matched by the employer up to a cap of, typically, 6%, while those who opted out or simply paid the minimum did not receive an enhanced employer contribution.

In April 2018, the minimum AE contribution rate increased to 5%, with an employer minimum of 2%. In April 2019, the minimum contribution rate will increase to 8%, with an employer minimum of 3%.

For employers, pensions-related payroll cost is a combination of those employees who either opted out of AE entirely (no cost) or pay the AE minimum (an employer cost of 2% until April 2019), and those employees who pay more and benefit from enhanced employer contributions (typical employer costs ranging from 3% to 6%).

Assuming that the employer has not borne the entire burden of AE minimum contributions, the employee only had to pay 1% until April 2018. Typically, from this year, that has increased to 3%, and will increase to 5% from April 2019. You can see why, if the employee is starting to make higher contributions, joining the employer's enhanced contribution scheme and getting matching contributions rather than the AE employer minimum is already starting to become more attractive.

Now, imagine this scenario playing out at a large employer with a pensionable payroll of £1 million, 75% of which relates to staff making minimum contributions (2% employer contribution) and 25% of whom are taking advantage of the enhanced scheme at a maximum 6% rate (6% employer contribution). This means a total pensions bill of £30,000 for our employer.

After April 2019, once employer contributions increase to 3%, the employer's total pensions bill would increase to £37,500, should the proportion of staff making minimum contributions remain the same. However, given those employees are now required to contribute 5%, those that can afford to do so would be better off joining the enhanced scheme and contributing 6%, matched by the employer. Assuming 75% of staff now take advantage of the enhanced scheme, leaving only 25% on minimum contributions (3% employer contribution), the employer's total pensions bill would increase to £52,500 - a £22,500 increase in a single year.

Of course, these figures are very fact-sensitive, and a lot will depend on whether your AE employees decide to opt out of pension saving altogether or not. Bear in mind that employees may be facing an increase from 1% to 5% of salary in just a few years, which may increase the numbers of employees opting out.

However, those employers who do offer the option of joining an enhanced scheme should model now what their increased costs could be as more employees start to see the benefit in saving more and getting their employer to help. Those employers who may find the potential increase challenging should start planning now how they may make the necessary pension changes in time.

Nick Stones is a pensions law expert at Pinsent Masons, the law firm behind Out-Law.com.