Progress on short service refunds
Once upon a time, long, long ago the vast majority of workplace pensions were final-salary defined benefit schemes run by trustees. Everyone could agree that periods of short membership of such schemes were an administrative headache all round. The law therefore allowed schemes to give employees their contributions back if they left before two years service, and to give the employer theirs back too.
Today workplace pension provision is very different. More people are paying into defined contribution workplace pensions than defined benefit pensions. Some defined contribution schemes are run as occupational schemes with trust based governance, but most are contract-based. These are provided by a commercial pensions company and cannot make short service refunds as this provision is only available to trust-based schemes.
Next year auto-enrolment starts. Over the next five years millions of people will start to save in a pension for the first time. Every employer has to choose a scheme. While there are guidelines and suggestions about how they should do that, the selling of pensions to employers of pensions is unregulated, unlike the sale of pensions to individuals where successive scandals have led to a reasonably tough regulatory regime.
Some pensions companies have suddenly seen the attraction of trust-based DC pensions because they can go to employers and say if you use one you can get your contributions back when members leave if they have been contributing for less than two years. In effect if you are an employer who has lots of workers likely to have short tenures – think retail, hospitality and other low-paid sectors – there is a ‘get out of auto-enrolment contributions free card’ if you choose a trust-based scheme.
Insurance companies can provide what is known as a master-trust arrangement, where a commercial arrangement is given a trust governance wrapper. In the past this has been used for multi-employer schemes. But pensions companies are now seeing them as a way of selling their products to employers, with short-service refunds as a prime selling point.
These not only undermine the auto-enrolment regime, but come pretty close to any common-sense definition of theft. Contributions paid by the employer into a worker’s pension retirement pot should belong to the worker, not be subject to a grab back by their boss if they happen to leave.
This is why Pensions Minister Steve Webb’s announcement today that he will end short-service refunds is very welcome. If there is any complaint it is that the timetable has been too relaxed.
A small pot in a defined benefit scheme does present genuine difficulties. Whether the employer contribution should go back to the employer or the member has always been controversial, but there has been an understanding that looking after small DB commitments was an unreasonable burden for employers.
This cannot be argued in DC schemes. A DC pot is just one lump of savings and investments among others. Small pots are proportionately more expensive to administer than large ones, and are thus not very attractive to providers. Yet they are easy to swap between schemes, in a way that DB contributions are not.
Auto-enrolment will produce many more small-pots, especially if the short-service refund loophole is closed. That is why the minister is right to say that we need to deal with small pots alongside ending short-service refunds. This provides a partial excuse for the timescale, although the TUC suggested that an interim measure would be to make the employer contribution go to the member, thus removing the employer incentive to exploit these refunds.
It makes sense for small pots to be consolidated. It serves neither member nor schemes to have lots of small pots distributed around many pension providers.
We also know that we will need a default mechanism. Of course members should be given a choice about where they move their pot when they change job, but we know that many will not exercise that choice. With pensions companies developing what they call active member discounts and the rest of us should see as deferred member penalties – ie higher charges for members no longer making contributions – it is not a good idea to leave a pot behind with an old scheme when you change job.
The government is now consulting about what should happen to small pots. The starting point for this should be the interests of the member. There has to be a default mechanism that guarantees small pots are transferred into a scheme that has the lowest possible charges and a default investment fund likely to serve the interests of lower income savers with small pots.
One obvious option is a default transfer to NEST, as that meets both these criteria (disclosure: I am a trustee member of NEST). But what is important is that scheme member’s interests are paramount, not those of employers or of pensions providers. Creating a default mechanism for dealing with small pots is in itself a boon for them. The precise details must serve the worker.