The Institute for Fiscal Studies has reopened the debate around how to tackle the proliferation of small deferred pension pots in a new report, ahead of expected legislation on the issue this year. 

The number of deferred money purchase accounts containing less than £1,000 reached 12.1m in 2023 and has been recognised as a problem by government and industry. The previous government planned to tackle the issue with multiple default consolidators and a central clearing house, estimating that small pots cost the industry up to £225m a year. 

Last summer, the new government said it would include measures on small pots in a new pension schemes bill expected this year, which will implement the multiple default consolidator approach. 

However, the government in theory also has the power to implement pot-follows-member. This power was given to it with the Pensions Act 2014 as the approach was due to come in for 2016, but pot-follows-member, proposed by former pensions minister Steve Webb, was then shelved by his successor Baroness Ros Altmann in 2015. 

The IFS has now said that either default consolidation or pot-follows-member would be preferable to the current situation, calling the status quo “not fit for purpose”. Its new research, published today as part of the ‘Pensions Review’ it has been conducting in partnership with the Abrdn Financial Fairness Trust, finds that “there is a strong case for deferred small pension pots to be consolidated by default, with people being given the option to opt out of this consolidation if they wish”.  

It adds: “There are merits of going further than just consolidating small pots, and moving towards a system where people end up with one DC pension pot, or only a very small number of these, as they approach retirement.” 

Laurence O’Brien, a research economist and co-author of the report, said the paper aims to set out in detail the reason why the status quo is not fit for purpose and create discussion about the pros and cons of policy solutions backed by data.

“I think it's a very important topic and we really hope that something will be done about this soon given that, as we say, there are loads of issues" with the current situation, he told mallowstreet.

Mubin Haq, chief executive at Abrdn Financial Fairness Trust, said the rapid rise in the number of small pension pots particularly affects lower earners and women. Who is most affected by the small pots issue has to date remained hard to pin down, but the IFS has looked at data about job changes over a period of time which found lower earners and women are more likely to have small pots.

Distribution of accumulated DC pension pots over a nine-year period, based on minimum pension contributions

“The new pensions dashboard will help many to keep track of their pensions, but it will not necessarily lead to consolidation of these pots. Further action is needed to reduce the complexity of managing small pension pots, which should result in gains for employees as well as providers,” Haq said. 

Though it does not clearly express a preference for one solution over another, the IFS states that “there are definitely advantages to the pot-follows-member approach”, such as greater saver engagement and funds not staying with legacy providers.  

This also avoids the “anti-competitive effect” from consolidating funds into a small number of providers, as is the case under the default consolidator approach, especially if the definition of what is ‘small’ changes. Conversely, this effect could mean that regulators or government will be loath to adjust the size limit of small pots upwards as they may need to mitigate competition effects.

The report also considers the lifetime provider model floated by the previous government – where an employee, rather than the employer, chooses a pension provider so that funds stay with the same provider when the employee moves jobs. The proposals were branded a ‘distraction’ by industry at the time and have not been pursued to date. 

The IFS says such a model would avoid constant flows of funds but could create extra hassle for employers and lead to higher fees, adding: “We judge that member choice and lifetime provider solutions should only be considered after fully implementing policies to consolidate deferred small pots automatically.” 

Independent policy adviser Daniela Silcock said she expects the new government to implement the multiple default consolidator model, noting though that Westminster has gone quiet about the issue over the last few months. 

“I don’t think the government has any appetite for pot for life or pot-follows-member at this point in time,” she said. 

Any automatic transfer system will require improvements to scheme infrastructure and methods of data sharing, she added.

“At the moment transfers are complicated, expensive and prone to error. We will need to invest some money and time in updating and improving the system in order for any of these to work,” she remarked. 

A government spokesperson said: “Our pension schemes bill will help over 15m people, including by bringing savers’ pension pots together in one place which could boost pension pots by £11,000, while our Pensions Dashboard Programme will empower individuals to better prepare for retirement.” 

Legislation to consolidate small pots may need to address the fact that small pots can be either trust or contract-based. The latter are individual policies requiring the savers’ consent for any changes, so consolidating them might not be possible without further legislative change. Last November, in the context of consolidating providers’ DC default funds, the government proposed to override scheme members’ contracts with legislation to allow them to be moved in bulk and consolidated at default fund level.