I always insist that the most important withholding task we undertake in payroll is for employee social security contributions.

Sure, income taxes are important, and the IRS (or its equivalent outside the U.S.) will pursue the taxpayer to the ends of the earth if taxes are delinquent, but in terms of personal impact on the employee, social insurance wins. Why? Because of the suite of important life event risks that social security covers.

Start of Social Security

Income tax provides indirect benefits covering society. Although we as a community benefit when the state builds new roads and maintains a police force, the pipeline is not as immediate as cash benefits are when you are sick, on maternity leave, unemployed, or suffer a work accident. If you have been lucky enough to avoid life’s bumpy roads (as I have after more than 40 years working), presumably, you aspire to reach an age where you draw a state pension. Put simply, social security is all about you, the individual.

We have the Germans to thank for the concept of universal social insurance, which was introduced in the 1880s by Chancellor Otto Von Bismarck, a historically autocratic character. He realised that the working classes were being increasingly attracted to communism, partly because of the living conditions of the time, so he decided to introduce a system of social insurances to provide a safety net to ease life’s woes. The following quote made to the German Reichstag in 1881 makes his vision clear:

“My social insurance system will give the worker the right to work while he is well, care for him when he is ill, and secure his care when he is old."

His statement still accurately surmises what social security is about today. Bismarck’s model envisaged individual pots of money for different risks and, in Germany today, health care, long-term nursing care, unemployment, pension, and work accident insurance are separate lines on an employee’s payslip.

The original German system identified that the world of employment was at least partly responsible for some common life event risks. Therefore, it was deemed equitable that employers should bear at least some of the costs of providing the coverage. Where systems give access to health care coverage, sickness, and family leave benefits, these also contribute to a happy, healthy workforce, which, in turn, should be more productive and useful to their employer. Everyone wins.

Payroll and Social Security

So, the key payroll task is to calculate contributions to be deducted from the employee’s pay, and contributions to be charged to the employer. Contributions are chargeable once an employee reaches the requisite age, which varies. In the UK, the requisite age is 16, whereas in Kenya it is age 18. An employee’s mandatory contributions usually cease or reduce at state retirement age, although the employer is often required to continue contributing.

Once liability has commenced, it is common for countries to have different contribution rates applied to diverse groups of employees, and allocating employees to the correct group is a key payroll task. Examples include the following:

• Young workers and apprentices
• Special types of employment (e.g., mariners, miners, agricultural workers)
• Employment carried out in specific locations such as disadvantaged areas of a country or in free trade zones
• Company directors

The contribution principle is at the heart of the operating model, in which benefits should directly reflect the amount of contributions made to the scheme. Simply, the more you pay in, the more you get out. But as schemes are designed as a safety net for the majority, there needs to be a cap placed so a millionaire employee will not receive millions in unemployment benefits. As you should only pay for what you are likely to receive, it is only equitable that your contribution liability should either cease or reduce at whatever upper limit has been placed within the scheme’s benefit structure. The use of earnings ceilings within the payroll calculation—a point at which income either for the period or the year to date is exceeded—facilitate this.

Income tax is often calculated on a cumulative basis, looking at annual income either by payroll or on the annual tax return. Social insurance, by contrast, is usually calculated by reference to the earnings for each pay period. This ensures that when periods of unemployment (and therefore no earnings) happen, the individual does not receive refunds as these would impact benefit entitlement. Work can be cyclical (e.g., tourism), so contributions are paid when work is performed. However, in countries where the earnings ceiling is an absolute cut-off, an annual equivalent calculation may be performed.

To illustrate this, let us look at the Netherlands’ progressive cumulative calculation (see example below). The ceiling for the relevant pay cycle (€5,969 per month) is multiplied by the pay period number and compared with the cumulative wage from the beginning of the year. Whichever of these two values is lower is then used and reduced by the cumulative income already subject to contributions in the year. Contributions on the balance remaining are calculated.

Calculation Example:

• Jan earns €5,000—under the ceiling—so all his pay is subject to contributions
• In addition to his normal salary in May, he is paid a bonus of €6,000, making his total salary €11,000
• His earnings from January to April total €20,000, but the monthly ceiling would be €5,969 × 4 = €23,876. He has €3,876 unused headroom to the ceiling.
• This makes the maximum ceiling for May’s pay €5,969 + €3,876 = €9,845
• €9,845 is subject to contributions, the remaining €1,155 is exempt
• In June, he earns his normal salary of €5,000
• 5 × €5,000 + €11,000 = €36,000 versus €5,969 × 6 = €35,814
• Take the smaller value and subject it to contributions
• So, contributions in June are calculated on €5,000 + €814 (the amount excluded in the previous pay period now liable for contributions)
• If pay remains at €5,000 in July, the remaining €341 of May’s excluded amount would also be subject to contributions
• From August onwards, if pay remains constant at €5,000 per month, contributions should match those deducted from January to April

The Progressive Annual Cumulative Calculation ensures that earnings up to the annual limit of €71,628 (€5,969 × 12) are subject to contributions. This stops companies from manipulating the system to their benefit. Consider Jan’s case in the example above: If the payroll software had simply used the monthly limit of €5,969, then €5,031 would have been excluded in May from social insurance. However, to understand such a complicated system, a good payroll system report will be needed to explain the numbers.

Working out just what parts of pay are subject to social insurance can also be a challenge. The definitions of taxable and insurable pay align together in very few countries. Indeed, social insurance premiums are often deducted from gross pay before income tax is calculated. Many pay elements that are deemed taxable may not be subject to social insurance—for example, termination payments. This is often determined by the nature of the payment; Payments of state social insurance benefits, such as sick or maternity pay, are often (but not always) deemed to be free of social insurance.

Additionally, the law itself might be confusing. Consider the liability for National Social Security Fund (NSSF) contributions in Kenya. The NSSF Act simply refers to “monthly pensionable earnings.” But the NSSF (Member Contributions) Regulations 2014 refer to this as being “monthly pensionable earnings excluding fluctuating emoluments.” Fluctuating emoluments are defined as “employee earnings not paid on a fixed basis, but additional to basic wage or salary and includes benefits in kind, acting allowance, special duty allowance, leave allowance, uniform allowance, equipment allowance but does not include bonuses, commissions, overtime, shift pay, house allowance and service charge.” Therefore, it is important for employers to clearly define the nature of all elements of pay they propose to use within contractual documentation.

Finally, what about the math to determine the contribution amount? Most countries use an exact percentage method of calculation (assessable pay × contribution percentage). But some countries opt for salary grades which usually involve a band of earnings being assessed for one standard cash contribution. This will have been calculated as being an exact percentage calculation on the midpoint of the band, and attention should be given in such systems for when employee salary rates change and cause the employee to move grades.

The Japanese system uses the concept of Standard Monthly Remuneration. The employer must calculate average monthly salary using the earnings from April to June each year. This average is compared to a table of 32 different earnings bands running from ¥88,000 to ¥650,000. There is a fixed contribution for each of the 32 salary bands. For example, band 30 covers average monthly income of between ¥575,000 and ¥605,000 with a standard deduction for that band of ¥53,985.

Getting social insurance right for our employees is an important payroll task. The effects will hopefully be felt for decades in the form of access to social security benefits. You can’t usually correct social insurance contribution liability via the individual personal tax return, so the results of our payroll handiwork will hopefully contribute to a happy and healthy life for our employees. Payroll data submissions concerning social insurance often include earnings data that goes directly into pension and benefit calculations. That is why I stand by what I said earlier: the most important withholding task we perform in payroll is for social security.