Why pension pots are not always better together

Pension Clinic: Steve Webb explains why combining pension pots can lead to the loss of valuable benefits.

One of the side effects of working for a number of employers over the course of a working life is that you may acquire several separate pensions along the way.

This is especially true today, as the law now requires employers to enrol workers earning more than £10,000 a year in a pension scheme.

A desire for tidiness may lead us to consider combining such pension pots. Indeed, with that in mind, new companies are being set up with business models based on enticing people to merge all their pensions into a single pension pot – which such companies will manage.

Pause for thought

It is worth pausing before combining all your pension pots in one place, however, especially if some of them were initiated many years ago.I have identified five situations where merging your pensions might not be a sensible idea.

1) Where you have an old pension (probably taken out before 2006) that has attractive tax features no longer available today, which could be lost if you transfer money out of the pension. For example, most pensions today let you take up to 25% of your pension pot as a tax-free lump sum, but some older pensions allow a higher percentage of the pot to be withdrawn tax-free. This is a valuable perk you will probably not want to lose. Similarly, current tax rules generally allow you to access your pension from age 55, but some older pensions allow access from age 50. It is important to check whether any of your pensions incorporate these features before you merge them into something new.

2) Where you have an older-style pension that has a 'guaranteed annuity rate'. When you want to turn a pot of money held in a pension into a guaranteed income for life, you must buy an annuity. Annuity rates are currently very low by historical standards. However, some older pensions guarantee an annuity rate that may be much higher than current rates. This guarantee could be lost if a pension pot is transferred into another pension scheme.

3) Where your pension has exit penalties attached. In the past, pension policies often incorporated features such as exit charges designed to discourage people from withdrawing money early. Most modern policies don't charge exit fees, but it is worth checking that you won’t incur unnecessary penalties if you move money out of an older pension.

4) Where you risk throwing away 'small pot' privileges (for those with larger amounts of pension wealth). The amount you can withdraw from a pension tax-free is limited to the lifetime allowance, but up to three pension pots worth up to £10,000 each can be withdrawn without that eating into your allowance. If you combine several small pots into one larger one, you could lose out on £30,000 of extra pension saving before you hit your lifetime limit.

5) Where you risk throwing away 'small pot' privileges (for those still building up their pension savings). Under current rules, people who start drawing taxable cash from their 'pot of money' (defined contribution) pension arrangements face a severe reduction in the amount of money they can pay into pensions in future. This takes effect under a rule called the money purchase annual allowance (MPAA). However, the MPAA rule is not triggered if you fully cash in a small pot worth less than £10,000.

Once again, consolidating small pots into one big one could reduce your flexibility and lead to you missing out on the benefits of special rules that apply to small pots.

It's natural to want to tidy our affairs and merging pensions into one pot rather than persisting with lots of small pensions seems logical. However, pension rules often have quirky features, such as special treatment for small pension pots, so it's wise to take expert advice before consolidating any of your pensions.

Steve Webb is director of policy at Royal London.

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