Two million now depend on profits for pay rises

As more firms link salaries to performance, Dido Sandler finds out who gains most

THE share option schemes enjoyed by some bosses have provoked widespread anger, based as they often are on self-assessments of performance.

But, as the Government is set to announce soon, the link between company profits and pay is now a year-round reality for 2 million employees.

These workers have joined profit-related pay schemes, entitling them to hundreds of millions of pounds in tax-free bonuses each year. PRP schemes allow members up to £4,000 tax-free a year, on top of personal or married person's allowance. The extra tax saved is calculated on the individual's top rate of tax. The schemes are simple, in theory at least. If profits go up, so does staff remuneration, giving PRP scheme members an incentive to contribute to their company's success. When profits fall, so can pay.

Lower labour costs generated with extra money clawed back from taxes would lead to companies taking on more staff, it was believed when PRP was introduced in 1987.

In fact, Andrew Dilnot, director of the Institute of Fiscal Studies, believes the opposite has happened: "It merely encourages companies and staff to collude to get deals that in no meaningful way incentivise staff performance. PRP subsidises people in employment. I find it hard at an economic level to find much justification for it to continue in its current form.''

PRP permits the lower figure of £4,000 or 20 per cent of salary to be paid tax-free, if specific profit targets are reached by a company's year- end. PRP schemes must be registered with the Inland Revenue and must disclose how payouts will be calculated. PRP is normally introduced into renumeration packages in one of four ways:

q As a tax-efficient and self-financing new bonus scheme, or part of one.

q As a replacement, or part-replacement, of an existing bonus scheme.

q Instead of all, or part of, a pay increase. If pay rises in successive years take the form of PRP, this gradually becomes more tax-efficient.

q Instead of part of existing pay, under a salary sacrifice arrangement. Staff take a cut in basic salary, up to a limit of 20 per cent. In some cases, employees benefit from the whole of the tax savings. Other alternatives mean they share that tax saving with their employers. Or they get the same net pay, while the saving is creamed off by the company.

According to the Confederation of British Industry, an employers' organisation, PRP motivates staff, boosting both company balance sheets and pay packets.

But Rob Donnelly, the CBI head of employee relations, admitted it can be difficult, especially in larger companies, to measure the precise link between profit and performance.

Sarah Kling, a partner at Coopers & Lybrand, the accountants, also backed PRP, arguing that money not paid in income tax filters back into the system - through corporation tax on profits, and VAT on additional spending. However, union critics claim - and some employers privately admit - that PRP is often used to keep pay settlements down, transferring to the taxpayer the burden of increases in take-home pay. To introduce a PRP scheme, a company must convince 80 per cent of its staff to vote in favour.

David Tuch, tax partner at the accountants KPMG, said: "There is an assurance by the company that if they miss profit targets, it will do something to make sure staff don't lose out. It isn't formally guaranteed, though."

In practice, clawbacks are not common. Lloyds Bank's PRP salary sacrifice scheme pays 95 per cent of PRP out to staff each month. It holds back the remaining 5 per cent.

Even if the bank misses the profit target and the 5 per cent is never received, the staff will have earned more in net terms than last year. Lloyds does not ask for its money back.

Derek Silver, general personnel manager of Gallaher UK, the US-owned tobacco company, stressed the need for trust in employer-employee relations for PRP to succeed.

Gallaher has paid staff bonuses as PRP since 1987. But even though staff benefited from the scheme, they asked to have it changed so that some of the money was included in basic wages.

This was because pension and overtime were calculated on the basic rate.

Peter Duboff, of the accountants Duboff & Co, said that mortgages could also be affected by PRP schemes: "Mortgage lenders vary in their assessments of pay for loan purposes - it's best to talk to them individually to find out." Lower basic pay could lead to less money being lent for home purchases.

A Bradford & Bingley spokesman said: ``Where a proportion of pay genuinely depends on how the company's profits go, most lenders act on the cautious side''.

He said in most cases, however, PRP was paid monthly as part of income, as a tax-efficient way of receiving pay. In these cases, the building society is prepared to include the monthly payments in its loan calculations.