There is an increasing awareness about the need to start planning for retirement from an early age and the benefits of pension saving have been dealt with previously in this column.

Examples include the tax relief that applies to contributions, as well as the tax efficient growth of the invested fund. However there is also an alternative method of making regular payments into a pension, that can be beneficial for both the individual and the employer. This is called salary sacrifice.

Salary sacrifice is increasingly being offered to staff by UK employers. It involves the individual giving up part of their salary in return for a non-cash benefit from their employer. This benefit can be in the form of a pension contribution.

The Pensions Advisory Service uses the example of someone who earns £30,000 per year and opts to give up £1,000 of their annual salary. The employer will therefore make a £1,000 pension contribution on behalf of the employee.

Salary sacrifice is also sometimes referred to as salary exchange and it can be used in conjunction with any type of UK registered pension plan.

A salary sacrifice arrangement must meet the standards set out by HMRC. According to Standard Life the most important point to be aware of is that the employee’s conditions of employment must be altered to reflect the new arrangement.

There must be a stipulation that a reduced salary will be taken in exchange for a pension contribution. An exchange of letters between the employer and employee will suffice in this regard.

The validity of the arrangement will also depend on the employee giving up their higher level of salary before it is subject to income tax and national insurance contributions.

HMRC does not need to be informed that a salary sacrifice arrangement has been put in place. However in order to ensure that an arrangement is compliant, most employers will seek some form of approval from HMRC at the outset.

The decision to make pension contributions by this method can be advantageous to both parties.

Primarily, the employee will take a reduced level of salary and therefore be subject to a lower level of both income tax and national insurance contributions.

The individual could decide to use these savings in order to top-up their level of pension contribution, whilst maintaining the same level of take home pay.

It can also be beneficial because of the way it allows high earning individuals to obtain full tax relief immediately. Members of a defined contribution pension scheme will typically get their tax relief under the ‘relief at source’ system.

The pension provider will automatically reclaim 20 per cent relief from HMRC, leaving higher or additional rate payers to claim the remainder via self-assessment.

By using employer pension contributions under a salary sacrifice arrangement, the relief would effectively be granted straight away.

Salary sacrifice can also be used by individuals who earn over £100,000 per year, and wish to reclaim their personal allowance.

There are also good reasons for an employer to set up a salary sacrifice arrangement. Companies must pay National Insurance on their employees’ salaries at a fixed rate of 13.8 per cent. If staff were to agree to a lower salary in exchange for a pension contribution, this liability would reduce, thereby creating a considerable saving for the company. This can be either be retained within the business or used to top up the staff’s pension contributions.

The downsides to such an arrangement must also be borne in mind and these stem from the fact that the employee will be taking a lower salary. For example, it may affect an individual’s ability to borrow for a mortgage. Likewise any employee benefits that express their sum assured as a multiple of salary - for example a death in service scheme - would also be impacted upon. These negative aspects should be considered, but salary sacrifice is a viable and increasingly popular approach to retirement provision with benefits for both employer and employee.

* Trevor Law is a director with Merito Financial Services, chartered financial planners, in Solihull. tilaw@meritofs.com