Millions of workers could have several pension pots from different employers, but combining them into one account is not always the best financial decision. While consolidating pensions can make them easier to manage and reduce the administrative burden of having money spread across different providers, experts warn that savers could lose valuable benefits by transferring an older pension.
Questions to ask before combining pension pots
Sarah Coles, head of personal finance at investment platform AJ Bell, said there are several questions people should ask before deciding whether to combine their pension pots. The first thing to establish is whether the pension is a defined contribution (DC) or defined benefit (DB) scheme, Sky News reported.
Most modern pensions are defined contribution schemes, where the employee and, in workplace schemes, their employer pay money into a pot that is invested. The eventual retirement income depends on the amount saved and investment performance. Defined benefit pensions work differently. They provide an income based on factors such as salary and the number of years spent in the scheme, usually paying a regular income for life.
Defined benefit transfers and valuable guarantees
Coles says combining one defined contribution pension with another can be relatively straightforward to assess, but transferring a defined benefit pension into a defined contribution scheme is a very different decision. She warns that people could be giving up valuable guarantees which would be expensive to recreate through a defined contribution pension and annuity.
There can also be a reason to keep some smaller defined contribution pensions separate. Pots worth less than £10,000 can fall under the small pot rules, which may allow someone to take the entire pension once they reach the minimum pension age without affecting certain pension allowances in the same way as accessing a larger pension.
Tax implications and charges to consider
However, savers need to consider the tax implications. Taking taxable income from a pension can trigger the money purchase annual allowance, reducing the amount that can subsequently be paid into pensions with tax relief from £60,000 to £10,000. Charges are another important consideration.
Older pension schemes can have higher fees than newer arrangements. Coles says that while there is a 0.75% charge cap on default funds in automatic-enrolment workplace pension schemes, some older pension policies and schemes outside automatic enrolment can charge more. Reducing the fees paid on a pension can make a significant difference over time.
Coles gives the example of someone combining three pensions charging 1.5% with a pension charging 0.75%. She says this could increase the pension pot by more than £7,000 over 10 years or £20,000 over 20 years. Savers should also check whether their existing pension has a penalty for transferring out. Pensions opened since 2017 do not have exit penalties, according to Coles, but older arrangements may have charges. People with certain with-profits pensions could also face a market value reduction if they transfer during unfavourable market conditions. This means savers need to weigh up any upfront cost against the potential long-term benefit of moving to a cheaper pension.
Guaranteed annuity rates and tax-free lump sums
One of the biggest reasons to think twice before transferring an older pension is the possibility of a guaranteed annuity rate. Some older schemes offered guaranteed rates of between 7% and 11%, according to Coles. These guarantees can be significantly more generous than rates available today, meaning transferring the pension could mean losing a valuable benefit. "If you switch away, you lose the guarantees," Coles says, adding that in many cases it can therefore be worth keeping these pensions.
Some older pensions also offered a tax-free lump sum worth more than the standard 25% available under modern schemes. Transferring such a pension can mean losing that protection, unless certain transfer conditions are met. For anyone planning to take the maximum available tax-free cash in retirement, this could be an important reason to consider leaving the pension where it is.
