Short-stayers get new right to keep pension

New rights for pension scheme members who leave with between three months' and two years' service took effect on 6 April 2006 and the Pensions Regulator's code of practice on reasonable periods for dealing with early leavers has also been approved. We examine the new requirements and the existing leaving-service provisions.

One of the many suggestions contained in the Pickering review of pensions (OP, September 2001) was that members who leave with short periods of pensionable service (that is, less than two years) should be provided with rights to vested benefits under their occupational pension scheme, subject to a de minimis rule. This was to ensure that people who change jobs frequently are able to build up pension rights, and to bring occupational pensions in line with personal pensions. While the government was enthusiastic about the general principle, as with many of the Pickering proposals, a watered-down version of the proposal has been brought into effect.

From 6 April 2006, members who leave pensionable service with at least three months' but less than two years' qualifying service, and who are not entitled to a vested benefit under the scheme rules, may choose between having a transfer amount (called a "cash transfer") representing the value of their scheme benefits paid to another approved arrangement, and a refund of their own contributions. Although the Pensions Act 2004 contains detailed provisions in respect of this new right, the Department for Work and Pensions (DWP) has made Regulations¹ expanding on some of the requirements (See New rights for early leavers ). The Pensions Regulator has also issued a code of practice² concerning reasonable periods for dealing with early leavers, which provides trustees and managers with guidance on the operation of the new provisions.

Leaving service - a reminder

If a member left an occupational pension scheme before 6 April 2006 without an entitlement to an immediate benefit and with less than two years' qualifying service, the scheme only had to provide a refund of the member's contributions, if any. Some schemes offered leavers with less than two years' service the same rights as those with longer service, but that was not required under the legislation and was not the norm. In addition, scheme rules could prevent a refund and require that members retain preserved benefits, though this was very unusual.

If a scheme is a contracted-out salary-related arrangement and a refund is made, the trustees must pay a contributions equivalent premium (CEP) to the state to reinstate the leaver back into the state second pension. The CEP, together with a 20% tax payment, may be deducted from the refund before it is paid, but schemes can add interest if they wish. If the scheme is a contracted-out money-purchase plan the protected rights deriving from the minimum payment cannot be bought out by payment of a CEP. Instead they must be retained in the scheme or transferred to another suitable pension arrangement. No refunds are permitted from personal pensions.

Once a member has completed at least two years' qualifying service the scheme must offer a preserved benefit to that member on leaving service. As an alternative, the member may transfer the value of their pension to another approved arrangement. The statutory right to a transfer applies until the later of six months after leaving pensionable service, and one year before reaching the scheme's normal pension age.

In most circumstances, members' benefits may not be transferred out without their consent. There are exceptions, including where the scheme is being wound up. However, a little known provision in the preservation regulations also allows the benefits of members with between two and five years' service to be bought out by the purchase of an annuity contract or insurance policy (what used to be known as a s.32 policy) without their consent. There are a number of conditions that have to be met before trustees may take advantage of this rule. In particular, the members' rights must not include protected rights and at least 12 months must have elapsed between the date on which the member left pensionable service and the purchase of the policy. Occupational Pensions is not aware of any schemes that take advantage of this provision.

New leaving-service rights

From 6 April 2006, members who leave pensionable service with at least three months', but less than two years', qualifying service, and with no rights to vested benefits under the scheme rules, may either have their contributions refunded, as under the old provisions, or opt to have the value of their benefits under a defined-benefit (DB) scheme, or the value of both employee and employer contributions in the case of a defined-contribution (DC) scheme, transferred to another appropriate arrangement.

In order to determine whether the member meets the three months' condition to qualify for a transfer, the following periods of pensionable service need to be taken into account:

However, if any of the rights that have been transferred from another scheme include rights transferred from a personal pension, no refund may be given. There is also no de minimis amount, so if members have three months' service they are entitled to transfer their rights elsewhere however small the value of the cash transfer.

Refund rules

If a member chooses to have a refund, the new Regulations allow the trustees to deduct any CEPs payable to the state and tax at the rate of 20%. The draft Regulations did not make any provision for interest or investment earnings to be added to the refunded contributions. Several respondents to the consultation commented on this and as a result the Regulations now allow for the amount of the refund to be adjusted to take account of interest or investment returns.

The Regulations also provide that the refund has to be increased if the trustees fail to act within a reasonable period in accordance with the Pensions Regulator's code of practice. It appears that this applies even if the trustees have a good reason for failing to act within a reasonable period. In a separate provision, the Regulations specify the rate of interest that must be added to the refund if the trustees have "no reasonable excuse" for failing to act within a reasonable period. Surprisingly, the code of practice does not specify what would be considered a justifiable reason.

Before paying any refunds, trustees also need to ensure that they are meeting HM Revenue and Customs requirements. If they do not, the refunds will be treated as unauthorised payments and subject to a tax charge. For the payment to be authorised, as well as not being entitled to a preserved pension, the member must not have been subject to a lifetime allowance test in respect of that scheme (so that no benefit crystallisation event must have been triggered under the scheme) and the refund must be paid before the member reaches age 75. The first condition means that if any benefits have been paid in respect of an earlier period of service with the scheme, the refund will be considered to be an unauthorised payment.

Any refunds made are subject to a tax charge of 20% on the first £10,800 and 40% on any amount in excess of this.

Transfer option

As an alternative to receiving a refund of their contributions, members who satisfy the three-month qualifying-service condition may choose to transfer the value of their benefits to another suitable pension arrangement on the termination of their scheme membership. An anomaly noticed by Mercer HR Consulting when the draft Regulations were published does not appear to have been removed from the final Regulations. This means that members with less than two years' service may opt for a cash transfer right up to their normal pension age, whereas those with at least two years' service have time limits placed on them.

For DC plans, the cash transfer is relatively straightforward to calculate. For DB schemes, the cash transfer is to be calculated in the same manner as cash equivalent transfer values (CETVs) paid for those transferring with service of two years or more. The draft Regulations provided that the minimum funding requirement (MFR) should underpin this amount for a transitional period until the scheme receives its first valuation under the new scheme funding arrangements (OP, February 2006). However, the DWP has been persuaded by responses to its consultation to drop that requirement. These suggested that it is safe to reduce cash transfers solely in accordance with the scheme's latest actuarial report produced under the actuarial guidance GN11. The DWP concluded that the MFR underpin would add an unnecessary complication in most cases.

Cash transfers have be adjusted in the same manner as refunds of contributions if the trustees fail to act within a reasonable period, with interest added if there is no good reason for failing to meet their obligations. Cash transfers may also be reduced in accordance with statutory provisions if the scheme commences to wind up after the member has left but before the transfer is paid. If the scheme starts winding up before the member leaves, the transfer option is not available.

Information requirements

The Regulations also set out details of the information that must be provided to leavers setting out their options. In addition to standard information about the amount of any refund and the cash transfer value as calculated in accordance with scheme rules, this includes:

Regulator's code of practice

Under the terms of the legislation, the Pensions Regulator's code of practice is restricted to setting out "reasonable periods" within which trustees and managers must notify members of their rights and give effect to members' chosen options. The code has now been approved by parliament (SI 2006/1383) and, strictly speaking, came into force on 30 May 2006.

The code is intended to offer practical guidance on what the regulator considers to be reasonable periods for the different stages of the process to be completed. It stresses that the time periods are not mandatory but failure to comply with them may be taken into account by a court or tribunal.

The process of informing members of their rights is divided into four steps by the code:

Reasonable periods

The draft code , upon which the regulator consulted, proposed that members should be notified of their rights within two months of leaving the scheme. However, some respondents were concerned that this period would be too short, as often the trustees are reliant on other sources for notification that the member has left employment. To meet these concerns, the regulator has lengthened the period and the code stipulates that members should be sent notification as soon as reasonably possible and that normally this should be within three months of leaving pensionable service. If the trustees are aware that it will take longer than three months to notify any member they should, as a matter of good practice, keep them informed of the situation.

The code then requires members to be given three months in which to reply. This period remains unchanged from the draft code, as does the three-month period in which trustees are expected to give effect to the member's wishes. If the member fails to respond within three months, the trustees may revert to what is called the default option, paying a refund of contributions after a further month has elapsed. The regulator originally suggested that the default period should also be three months. However, a number of respondents queried the relevance of having any default period. The regulator takes the view that the legislation requires a default period, so has settled on a month as being appropriate.

In practice, the process could well be messy. Inevitably, many members will reply by the deadline opting for a transfer, but without giving sufficient details of where they want their cash transfer paid, even though the code states that members must specify how it is to be used. Trustees might want to consider the design of their forms and administration procedures to minimise the risk of this.

Constraints on the time periods

The flow chart shows how the process should work in practice. However, as can be seen, there are some further limits imposed on the time-scale within which trustees must act.