Pensions briefing - Goodbye to DC short service refunds

Currently, members of occupational pension schemes with less than two years’ qualifying service can leave and opt for a refund of their own contributions. This is known as a “short service refund”.

Legislation taking effect on 1 October 2015 will prevent trust-based money purchase or defined contribution (DC) schemes giving a short service refund to a new joiner on and from that date unless he leaves pensionable service (that is, membership of the scheme) within the first 30 days of membership.

The change does not affect members of final salary or defined benefit (DB) schemes who will remain entitled to a refund of contributions if they leave the scheme with under two years’ qualifying service.

The new provisions operate to bring the vesting period in trust-based DC schemes in line with the 30-day “cooling-off period” that applies to contract-based personal pension arrangements and the one month opt-out period applying in qualifying schemes used for auto-enrolment.

The current preservation requirements for occupational schemes are set out in the Pension Schemes Act 1993 (the PSA). Once a member has more than two years’ pensionable service, section 71 of the PSA requires that he is provided with a deferred pension (a “short service benefit”) if he leaves before the scheme’s normal retirement age. For a member with between three months’ and two years’ pensionable service at the time he leaves the scheme, the PSA provides the right to choose between receiving a short service refund or transferring a cash sum to another pension arrangement.

Section 36 of the Pensions Act 2014 amends section 71 of the PSA so that where all benefits provided by a scheme are money purchase (under the new statutory definition, as discussed in our November 2013 briefing), entitlement to short service benefit begins sooner than before - when a member has 30 days’ qualifying service. Effectively, this means that there will be a 30-day vesting period for short service benefit in relation to all individuals who join or re-join (following a previous refund or transfer) an occupational DC scheme on or after 1 October 2015. However, DC members who joined the scheme before that date and who have more than 30 days’ service will still be able to take a refund of their contributions. This means that the end of the run-off period for paying short service refunds for existing members could be paid as late as October 2017.

The abolition of short service refunds does not affect DB schemes. Neither does it apply in schemes where some of the benefits payable to a member fall outside the statutory definition of “money purchase”. This means schemes which apply, for example, a DB underpin. However, where schemes provide both DB and DC benefits, whether or not they retain the ability to make short service refunds to members having less than two years’ qualifying pensionable service will depend on the scheme’s structure, and advice should be sought.

Unhelpfully, the legislation is not overriding and trustees of occupational DC schemes should review their rules to check whether the two year period for short service refunds is “hardwired” into their provisions. Failure to amend scheme rules to reflect the new requirement to preserve benefits after 30 days for members who join the scheme after 30 September 2015 could result in an inadvertent unauthorised payment of a refund, with potential tax repercussions.

Member communications should also be reviewed to ensure they accurately reflect the new position, so that members have no false expectation of a refund of contributions after 30 days’ scheme membership.

Prior to 1 October 2015, when refunds of contributions were made to members, the employer’s contribution element could be retained in the scheme to cover administration costs. The change could have cost implications for employers with a high staff turnover, and may lead employers to reconsider the shape of their scheme provision, as contract-based schemes may now be more appealing, due to the greater simplicity of administration.

In addition, where members miss the 30 day deadline for the contribution refund but subsequently leave employment, there could be a noticeable increase in the number of small pension pots to be administered.

The previous Coalition Government proposed a “pot follows member” policy under which small money purchase pots would transfer automatically to the member’s new scheme when he changed jobs. The introduction of such a system was intended to alleviate the potential problem of an increased number of small pots. The current Government has indicated that it does not intend to implement automatic transfers until late in 2016, but has nevertheless pressed ahead with this related change, which leaves scheme administrators with something of a mis-match.

The abolition of short service refunds reflects the Government’s intention (via auto-enrolment) to encourage members to retain their contributions within pension schemes instead of cashing them out when they change jobs. The obvious hope is that this will boost savers’ efforts to build up adequate pension savings for their retirement, although it is rather at odds with the policy on pension flexibilities. Unfortunately, there is an inconsistency which needs to be addressed between the legislative provision of a 30 day deadline for a short service refund and the “one month” opt-out period set out under the auto-enrolment provisions, creating a further headache for administrators.

However, until the outcome of the current consultation on the shape of future pension tax relief is certain, it is difficult for savers to have any confidence that their savings will produce the pension they hoped for during their working lives.