In the age of automatic enrollment in workplace pensions, starting a new job usually means starting a new pension.
And with 7-8 per cent of us switching to a new job in any given year, we will soon see a proliferation of ‘deferred’ pension funds, those left behind when we change jobs and start a new ‘active’ fund.
Looking solely at master trusts, which are the main providers of workplace pensions in the UK today, the Pensions Policy Institute has estimated that by the mid-2030s there could be 27 million deferred pensions .
When pensions are spread out, it can be difficult for people to understand their overall position and plan effectively. Therefore, there are often obvious advantages to putting the pots together. But what is less well known is that there are also potential drawbacks, particularly in the loss of benefits associated with older schemes.
A worker in the UK today could easily have one or more ‘defined benefit’ pensions from previous jobs, some older defined contribution (DC) pensions taken in the era before automatic enrollment started in 2012, as well like multiple modern DC pensions from recent jobs. In the future, workers could easily have half a dozen or more different CD pension funds throughout their careers from different providers.
The government’s proposed pension panel is likely to give consolidation a big boost, because people will see all their pensions, including amounts they may have lost touch with, in one place for the first time. There are also new companies entering the pension market actively promoting their services as a ‘consolidator of choice’ and offering a more user-friendly approach to pension savings.
While regulators consider transferring out of DB pensions unlikely to be in the interest of enrollees, the case for consolidating DC pensions is much stronger, especially those drawn in an earlier era.
One of the strongest reasons for consolidation is to benefit from the typically lower charges associated with modern workplace pensions. All schemes used for automatic enrollment have a charge cap of 0.75 per cent per annum for money held in your default fund, and the average charge is currently just under 0.5 per cent per annum.
By contrast, an older pension could easily charge twice as much, in some cases reflecting the need to recoup commission costs when the product was originally sold. Even seemingly modest differences in fees can make a significant difference in the ultimate size of a pension fund. We estimate that someone with average income saving over their lifetime in a pension charging 0.75 per cent will end up with a pension fund around £37,000 larger than the same person facing a lifetime charge of 1 per cent. .0 percent.
But consolidation isn’t just about charges, it’s also about investment.
If you have a pension, you are an investor and the most important choice all investors must make is the balance between risk and return. With retirement savings scattered across multiple funds, it can be hard to get a big picture of what your money is invested in, let alone make sure the combined investment mix makes sense.
Having money stuck in old pension funds can also mean missing out on best practice investment approaches. For example, old pensions may be more biased towards UK investments, missing out on the benefits of diversification abroad. Similarly, modern pensions are more likely to have an allocation to asset classes such as infrastructure that would have been less common in earlier decades.
But when it comes to consolidating pensions, it’s important to pause for thought. It is crucial to fully understand what you are giving up before transferring.
Older ‘legacy’ pension products may have valuable features that could be lost in the event of an individual pension transfer. One of those features would be a ‘guaranteed annuity rate’, which would lock in regardless of prevailing market rates at the time of retirement. As the last decade has seen a collapse in annuity rates, giving up a high, guaranteed rate on an old pension could prove to be a very costly mistake.
Older pension products may also have tax benefits that are no longer available. For example, they may allow you to take more than the current limit of 25 percent in tax-free cash, or they may allow you to access your pension before the normal minimum pension age.
In addition, many deferred pension funds tend to be quite small, and small funds attract certain privileges that would be lost if they were consolidated into a single larger fund.
For example, someone flexibly accessing a DC pension fund worth more than £10,000, perhaps due to short-term financial pressure, could see their annual pension allocation reduced for future savings of £10,000. Normal 40,000 to just £4,000 (so-called ‘Annual Money Purchase Allowance’) for the rest of your working life. But DC jackpots under £10,000 are exempt from this penalty, meaning consolidation could be a mistake for someone in this situation.
As our new paper demonstrates, there are many attractions to pension consolidation, and there is potential for both lower costs and a more optimal investment strategy. But those considering consolidation should ‘look before they leap’, making sure they fully understand the value of what they are giving up and not just focus on getting their pension matters in order.
Sir Steve Webb and Dan Mikulskis are partners at LCP and authors of “Five Good Reasons to Consolidate Your DC Pensions and Five Reasons to Be Careful,” published August 2022.