Frequently Asked Pension Question: 1% of What?

Percentage in the skyWhen business owners set up a company pension scheme they need to make a few choices, including deciding how much the business needs to pay into the pension. Many employers understand that this must be at least 1% but few seem to know that there is more to decide than the percentage: do they want 1% of the total wages, 1% of qualifying earnings, or something else?

“Qualifying earnings” is an important concept for automatic enrolment because it is the earnings band employers should use if they want to minimise their costs. Some business owners want to keep costs to a minimum, which is done by paying 1% of qualifying earnings. Other employers are happy to put in a little extra and they may choose to pay a percentage of the total wages – of course this has the advantage of being easier to understand. Nevertheless, it is clear that both types of employer need guidance to help them make their choice.

The definition of qualifying earnings comes from section 13 of the Pensions Act 2008 and includes figures which, from time to time, are increased. After the latest increase it points out that, “A person’s qualifying earnings in a pay reference period of 12 months are the part (if any) of the gross earnings payable to that person in that period that is – (a) more than £5,876, and (b) not more than £45,000.” The act goes on to explain what counts as “earnings” and how to deal with different pay reference periods. My key point here is that the Pensions Act states that qualifying earnings are the wages between two limits, and so the first part of earnings is disregarded.

Most employers don’t read legislation directly, but depend on guidance from other sources. These sources take on the difficult task of converting legislation, which can be complex and ambiguous, into simple, easy-to-follow language.

The Pension Regulator has some guidance about contributions and funding: the web page runs to about a thousand words but fails to mention that employers can use a band of earnings. It does, however, include a link to detailed guidance which, on page 19, has a good explanation of qualifying earnings, consistent with the legislation.

For the benefit of our customers, we’ve put an explanation of qualifying earnings in our FAQ.

Sometimes it is helpful for guidance to introduce new terms to make it more accessible to the public. What is counterproductive, in my opinion, is the practice of redefining terms in the guidance which mean something slightly different in law.

This brings me to the explanation of qualifying earnings on gov.uk, which states that qualifying earnings are calculated from either:

  • the amount you earn before tax between £5,876 and £45,000 a year
  • your entire salary or wages before tax

The first option matches the legislation. However, by saying that you can use the term “qualifying earnings” to mean the entire salary, it not only contradicts the legislation, but it also makes the term ambiguous. I reported this problem with the page back in 2015. It is a small point, but employers need a simple phrase can be understood by both pension companies and payroll – after all, the contributions must be agreed with the pension company and then calculated by the payroll system, so it helps if they speak the same language.

To give the same, key phrase a different meaning can cause great confusion. If I ask whether you want the contribution to be 1% of total wages or 1% of qualifying earnings and you have read the definition on gov.uk, you may well answer, “both”.

Steven Tucker

By Steven Tucker - Co-founder

Steven is one of the founders of The Payroll Site. He writes about things affecting small businesses, especially those things connected with payroll. He's also a Maths graduate and a Chartered IT Professional and has a few views about technology, maths and the misuse of both.